Prime Your Portfolio

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In horseracing, there's a distinct difference between a "prime" bet and an "action" bet. The latter is a wager made on impulse, moments before the next race begins, in hopes that a long shot will pay off big. It's sort of like the temporary insanity that hit me last summer; I'd just closed out some winning positions, found myself with plenty of cash in my brokerage account, and wound up making a less than ideal investment.

Starbucks (Nasdaq: SBUX) was trading around $26, off a high of about $40. This stock just had to go back up, or so I thought. Of course, I didn't consider that restaurant traffic was flat to down, and that the $40 high I was fixated on represented a P/E ratio of about 50. In short, I made a bad action bet.

A prime example
A prime bet is completely different -- in fact, it's scarcely a bet at all. Rather than gambling, the wagerer does due diligence, carefully weighing a prospect's potential future success.

Investing gurus like Warren Buffett rely upon this strategy. As his most recent stake in Kraft Foods (NYSE: KFT) demonstrates, Buffett carefully selects best-in-class firms with stock prices pummeled by short-term setbacks, but which retain fundamental long-term upside potential. It's irrational to purchase shares of stocks with falling prices just because you think the shares will eventually rebound. You need meticulous analysis to ensure that a company's operations don't warrant the drop.

Since I stick mostly to retail and restaurant stocks, I went back to the drawing board to find two stocks that have similar characteristics:

• A long-term, successful underlying business franchise.
• A stock price beaten down in recent months by temporary factors.
• Significant potential for P/E multiple expansion in the future.

This shoe fits
Among small-cap retailers, I have my eye on DSW (NYSE: DSW). Over the past year, this company has quietly lost more than half its market value, watching its P/E contract from more than 30 to its current 12.

Based on a 1.7% same-store sales decline in the fourth quarter, analysts aren't expecting stellar news when earnings are released in late March. The company ended its third quarter with inventories a little on the high side, so markdowns will probably make this quarter a washout.

Yet aside from current economic conditions, which are putting the hurt on nearly every retailer, DSW's underlying business model hasn't changed: Offer customers a wide assortment of value-priced shoes that typical department stores can't match. This same strategy has delivered annual growth greater than 15% in sales and 30% in earnings since the company went public in 2005.

At just 259 stores, this retail value player has plenty of room to grow. CEO Jay Schottenstein has been stocking up on shares, the company's balance sheet carries no debt, and its valuation appears priced for little or no growth. Discerning investors in the Motley Fool CAPS community see the opportunity here, rating the stock four out of a maximum five stars.

A stock to try on
Similarly, Kohl's (NYSE: KSS) has many of the same characteristics. In the third quarter, the retailer piled up unsold inventory, while comps fell 2.7% and sales rose just 5%.

But again, this company is battling current macroeconomic difficulties, because of the soft consumer environment for apparel. Even so Kohl's is full of significant growth potential. Last October, Kohl's announced plans to grow its store base from 58 to 1,400 by the end of 2012. Management predicts 15% to 17% earnings-per-share growth during that time frame. Considering it's averaged similar rates annually over the last five years, that seems like a pretty feasible target.

I also favor Kohl's uncanny knack for developing private-label brands that hit the sweet spot of quality and fashion with its loyal customer base. With its business model still intact, and selling at just 13 times trailing earnings, this looks like a stock with a lot more upside than downside over the next few years.

So there you have it -- my two Buffett-like picks in the world of retail, solid companies selling on the cheap due to short-term macro setbacks. Call me crazy -- or take a closer look and decide for yourself whether they truly look like prime selections.

For related Foolishness:

• Kohl's unveils the secrets of its success.
• DSW showed some fancy footwork last year.
• This Fool wonders if Kohl's is Cool?.