For the novice investor, choosing an appropriate investing strategy can be a challenging, yet critical first step. To be sure, there are a dizzying variety of theories to choose from, each with a large group of proponents who claim that their methodologies are the surest way to achieve market beating returns. Trying to decide between growth versus value, fundamental versus technical, top-down versus bottom-up, and active versus passive investing styles can sometimes be an overwhelming task for investors.

Not surprisingly, people with different attitudes and philosophies are naturally drawn to different types of investments. Those with high risk/reward profiles, for example, may be attracted to growth investing, which places a premium on fast-growing businesses. Growth investors believe that companies with accelerating sales and earnings offer the highest potential returns, regardless of valuation levels.

Others belong to the "momentum" school of thought, where relative strength is valued above all else. In other words, they simply buy whatever is currently going up and sell whatever is currently going down.

Then there are technical analysts, who use a basket of complex tools such as moving averages, buy/sell indicators, and chart patterns to decipher stock movements. These traders essentially ignore fundamental data found on the financial statements. Instead, they insist that the best way to predict short-term trends is to carefully study a firm's price chart.

Each of these different strategies -- as well as dozens more that I haven't listed here -- has a unique set of pros and cons. Under the right circumstances, they can all deliver attractive results. Nevertheless, I've chosen to disregard most of these approaches and to instead focus my attention on the same corner of the market that has made money managers like Warren Buffett, Peter Lynch, and Bill Miller legendary -- value stocks.

The Case for Value Investing
According to research firm Ibbotson Associates, between 1968 and 2002 value stocks delivered an impressive annual return of +11%, easily outpacing the +8.8% return of growth stocks -- and with less volatility. Furthermore, a number of studies have also shown that small companies tend to outperform large ones over the long haul. With this in mind, I focus most of my energies on analyzing small- and micro-cap value stocks.

Value investors can certainly appreciate companies with impressive growth rates, healthy balance sheets, expanding profit margins, and other such sought-after credentials. However, true value investors are also not afraid to dive into stocks with deteriorating fundamentals either. Why? Because value investors are essentially bargain hunters, and companies with spotless financial statements seldom trade at rock-bottom prices. On the other hand, businesses that have been shown to have a few chinks in the armor will often see that weakness reflected in their share price. Given the market's tendency to overreact, bad news often triggers strong selling pressure, and this pressure can quickly push a company's shares far below their intrinsic value.

In general, I prefer to scour the market for troubled stocks that are trading at a significant discount to their intrinsic value. For example, I'd much rather buy a troubled stock that's worth $5 and is trading at $3, as opposed to purchasing a flawless company valued at $40 and selling for $45. Obviously, these numbers are entirely hypothetical, but they do illustrate one of the central themes of value investing -- the path to riches doesn't involve the search for fantastic companies, but instead for undervalued ones.

How to Uncover Winning Value Stocks
So, how does one develop a method to uncover stocks that are trading below their intrinsic value? Unfortunately, no perfect system exists. There is no road map to follow, and no rule of thumb to use as a guideline. Even financial ratios, which are virtually indispensable to the value investor, are by themselves not enough. After all, anyone can memorize a few simple formulas. Furthermore, financial statistics can easily be distorted by one-time events or recent transactions that are unlikely to be duplicated.

None of this is meant to dissuade anyone from value investing -- only to caution that the process is research-intensive. There are no shortcuts. The key lies in not just crunching the numbers, but also understanding what they mean and then drawing the correct conclusions. A successful value investor will also understand that what lies beneath the numbers can be equally important, and that qualitative factors such as management, competitive advantages, brand loyalty, and barriers to entry should also be weighed.

With all this in mind, in PART II of this article, which I'll publish in the coming days, I'll bring you a closer look at some of the specific methodologies that I use to uncover quality value candidates.

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Important Note: The above article was merely a small excerpt from a recent issue we sent to subscribers of our premium value investing service -- Margin-of-Safety Investing. In each issue of that newsletter, editors Nathan Slaughter and Paul Tracy deliver an in-depth look at a variety of other deeply discounted stocks that should provide investors with a solid margin of safety at current prices. To receive your copy of our most recent issue of Margin-of-Safety Investing, as well as other guidance similar to this twice per month, you'll need to subscribe to this publication. To learn more, please visit:
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