Here's a story about a friend of ours; let's call him Fred. Fred's a fairly seasoned investor, except that he takes what he calls "flyers" -- small bets on story stocks or stocks with what they call momentum. Some days he's a joy to be around -- other days it pays to steer clear.

Those bad days, as you might have guessed, are the days when one -- or, heaven forbid, two -- of his flyers suffers a 30% stumble. One day it's a tiny driller for black gold. The next it's a drugmaker that had its only significant drug prospect halted by the FDA. Then it's a company that lets you make your own teddy bear, of all things.

What do all of these flyers have in common?

  • They're expensive.
  • They're hyped on Wall Street.
  • They're on CNBC and all over the chat boards.

They're what we in the business call overextended. And they're sure as heck not the kind of stocks we talk about -- at least in a good way -- at Motley Fool Inside Value.

According to well-known research firm Ibbotson Associates, value investing flat outperforms both growth investing and the S&P 500 by a wide margin, especially during recessions. In all seven recessionary periods since 1970, value stocks outperformed, returning an average of 3.1% versus a loss of 0.8% for growth stocks.

While impressive, the percentage difference doesn't tell the whole story. According to Fama and French, $10,000 invested in large-cap value stocks in 1956 grew to over $5.1 million 50 years later -- versus just $1 million for large-cap growth stocks.

It seems clear. If you want better returns, be a value investor!

Borrowing from the masters
At Inside Value, we have had quite a discussion as to what constitutes value and who qualifies as a value investor. Some take the Benjamin Graham route, looking for deeply undervalued stocks that are trading at or below book value and preferably at a discount, or margin of safety, of at least 50% to their estimation of the intrinsic value. These are the "deep value" guys, and when the stock approaches fair value, they sell and repeat the process.

Renowned investor Eddie Lampert has made a killing picking up companies like AutoZone (NYSE:AZO), Kmart, and Sears Holdings (NASDAQ:SHLD) when the Street shunned them. He saw the real estate value in Kmart and Sears, and the cash-producing assets of AutoZone. When we started Inside Value, our very first pick, MCI, fell into this category. A few months later, we sold it for a 50% return (including dividends).

Others are more like Warren Buffett, still looking for a big margin of safety with the caveat that they are prepared to pay up for companies that truly display long-term competitive advantages. These are companies such as Wells Fargo (NYSE:WFC) and Coca-Cola (NYSE:KO). Wal-Mart (NYSE:WMT) could well fall into this category today.

Then there are others that follow the path less traveled and are true contrarian investors, such as David Dreman, highly successful manager of the Scudder-Dreman funds and author of Contrarian Investment Strategies. Dreman looks for value in distressed companies that few others want, like Altria (NYSE:MO) in 2003, when the stock dropped below $30 on fears of massive litigation awards. Since those lows, Altria more than doubled before spinning off shares of Philip Morris International (NYSE:PM).

There is a clear and consistent theme in all these cases. In each, the value investor assesses the intrinsic value and applies some margin of safety to establish the buy price. The value investor then waits patiently for the stock price to drop below the buy price and will not chase a rising stock price above that level. The next component again involves patience -- the patience for the market to recognize the undervaluation.

The hunt for value
We don't have a hard-and-fast rule that shares must trade at a 40% discount to conservative estimates of fair value before we'll invest in a company. In my mind, not all companies or stocks are created equal. With some stocks, we don't ever expect to see a 40% discount, but if earnings are predictable over a very long period, we might be prepared to buy them at a smaller discount to my estimation of intrinsic value.

This is what we discuss in every issue of Inside Value. You've read this far, so apparently you share some of our thoughts on investing. If you're trying to decide whether to take the next step, let us help make your decision a little easier. Try a risk-free 30-day trial on us. If you are not 100% convinced that Inside Value will make you money, you won't pay a dime. Either way, you owe it to yourself as an investor to learn about value investing.

So, until we chat again, we wish you good value investing. Oh, and Fred, try to stay away from those flyers.

This article, written by Philip Durell, was originally published on Nov. 5, 2004. It has been updated by Dan Caplinger, who owns shares of Altria and Philip Morris International. Coca-Cola, Wal-Mart, and Sears Holdings are Inside Value recommendations. Fool disclosure rules are here.