Stocks on the Rise

It's easy -- and useful -- to follow the crowd at times. Folks follow trends in fashion (what's in for spring?) and electronic gadgets (another iPod, anyone?), for instance. But following the crowd as an investing strategy? That's an entirely different story. For those of us who had huge losses in the post-2000 Nasdaq crash, it's one we'd like never to repeat again.

Sure, if you get in early enough, you can make some big short-term gains by following what's commonly called "momentum investing." There's even a pretty savvy measure you can use to push these dollars up the hill, known as "relative strength." But for most of us, that's a recipe for buy-high-sell-low disaster.

Take advantage of the herd
Value investing -- preached by a few luminaries you may have heard of (Graham, Buffett) -- can help you buck such a herd mentality. Value investing involves using financial metrics to determine which companies have the potential for long-lasting returns. But the important thing is to wait for the rainy day when the market panics -- and buy the stock at a discount to its intrinsic value.

Consider a few examples:

1. The aforementioned tech bubble
In 1999 and 2000, Rambus (NASDAQ:RMBS) was the next big thing -- just like Corning (NYSE:GLW), Powerwave Technologies (NASDAQ:PWAV), Adobe (NASDAQ:ADBE), and Buyjunknow.com. As investors who played the momentum game back then now know, following the train (wreck) can lose you some hefty stacks of cash.

But if you'd recognized the worth of these companies and their business models while the market was reacting to the crash, you could have found some real value. The average gain for these four companies from the end of 2002 is more than 280% (or 34% annualized). That's a lot of incentive to be contrarian when the masses are screaming "Buy!" or "Sell!"

2. Overanalyzed and overhyped IPOs
For a more recent example, look at Baidu.com (NASDAQ:BIDU). It IPO'd late in 2005 at $27 a share, shot up to $122.54 a share purely on momentum, and then plummeted to less than $50 a share. If you'd followed the momentum crowd, you would have lost a significant amount of money when you sold on the weakness. But if you bought Baidu contrary to the crowd, you could have gotten in at the low price and held for a 260% gain.

3. Great business, short-term worry
According to Jeremy Siegel's The Future for Investors, the best-performing stock in the entire S&P 500 since inception has been Altria, with an annualized return of 19.8%. But even this mammoth performer had its ups and downs when the momentum crowd was changing its mind -- the company's stock price went from a split-adjusted high of nearly $60 a share in 1998, to less than $20 just two years later. This is a prime example of a value play. If you had the knowledge and courage to invest in a great company when the rest of the market was overreacting to a negative outlook, you would be very happy with your returns today.

Up and down, and back around
Value investing can help you beat the momentum crowd. It's where you find a great company and simply wait for it to go on sale.

Even the greatest of great companies fall out of favor at times. It happened to long-haul market-beaters like Altria, and today's market offers several more opportunities.

Marsh & McLennan (NYSE:MMC), a recent formal recommendation in our Inside Value service, is one such opportunity. Inside Value advisor/analyst Philip Durell believes that two scandals in the company's history have brought the stock into value territory. But now, as Philip said when he recommended it, "with new management and a new structure, the company is emerging from a long, dark tunnel." 

Philip's record for bargain-shopping is impressive -- Inside Value picks are nearly seven percentage points ahead of the market on average, and plenty of his recommendations are still trading at what he considers to be bargain prices. You can find out what they are by clicking here to be Philip's guest at the service free for 30 days.

Everyone wants a piece of a stock on the rise. But by being a value investor, you can find stocks before they rise.

This article was originally published on April 17, 2006. It has been updated.

Fool contributor Shruti Basavaraj does not own shares of any company mentioned. Baidu is a Rule Breakers recommendation. The Fool's disclosure policy is sealed for freshness.