Jump on the Rally to Come

Tumultuous as the past 12 months have been, we could be in for additional roller-coaster action. The market's long past wondering whether we're in recession; now it wants to know just how severe that recession will be. The former, in my view, is already priced in. After all, the market is nearly 40% off its all-time highs.

Whether these prices also anticipate a severe recession is a tougher call. But given the apocalyptic spiral of the last several months, a sharp and protracted downturn might already be factored into the market's current level, too.

And with variables like that, it's hard to tell which companies are poised to outperform.

History lesson
Everyone's an armchair prognosticator these days -- it's hard to resist while watching our portfolios shrink and swell by 10% or more week over week -- but what we really need are a few armchair historians. With that in mind, here are a couple of factoids that long-term investors ought to keep in mind as they ride out the market's dramatic performance swings.

  1. Historically speaking, the stock market is a leading indicator, typically bouncing back well in advance of the overall economy.
  2. Between 1926 and the close of 2007 -- a stretch of time that includes the Great Depression, the moribund economy of the 1970s, the fabled "black Monday" of October 1987, and a portion of the recent downturn -- the S&P 500 delivered an annualized return of 10.43%.

Do the math
With an annualized return like that, a mere $1,000 invested at the beginning of the period would have morphed into more than $3 million by the end. And while we seem these days to be living through a once-in-a-lifetime event, I'd argue that investors are also being handed once-in-a-lifetime opportunities.

To wit: High-quality overachievers such as IBM (NYSE: IBM  ) , Bank of America (NYSE: BAC  ) , and UnitedHealth (NYSE: UNH  ) -- each of which has outperformed the broader market for the 10 years that ended with September -- are currently on fire sale, trading at prices more than 30% below their respective 52-week highs. Chevron (NYSE: CVX  ) and Lowe's (NYSE: LOW  ) fit that deeply discounted profile, too, as do the growth-oriented likes of Google (Nasdaq: GOOG  ) and PepsiCo (NYSE: PEP  ) .

How to proceed
Past performance is certainly no guarantee of future results. Smart investors should sift through the rubble not just for those companies that have performed well historically, but also for firms whose forward-looking prospects are similarly bright. When it comes to making that call, I'm a big fan of companies that can show me the money -- i.e., free cash flow (FCF) -- and that have key profitability metrics, including returns on assets and equity, that rank among their industries' finest.

Management withs the courage of its convictions is key, too. Share repurchase programs and substantial inside ownership are high on my shopping list when I scour the market's blue-light aisle for potential purchases.

Is the price right?
That last item gets at what is likely the toughest code for most of us to crack: valuation. Comparatively speaking, it's easy to find a great company; it's infinitely harder to find a great investment. Indeed, sometimes terrific companies can make lousy investments.

That's often the case, for example, when investors pay up for past earnings growth, or for the Wall Street optimist club's estimates of a company's future earnings stream. In my view, it's better by far to focus on cash flow, which is much less susceptible to financial fudging than earnings. Companies with a steady stream of the stuff lend themselves to much more reliable valuations, too.

Bottom line: When a firm has a track record of delivering ample FCF, savvy investors are in a good position to infer the actual worth of the firm, compare it with the price the market has currently assigned, and determine whether the difference between those two figures represents a bargain.

The Foolish bottom line
In a nutshell, that's the approach we've taken at the Fool's Ready-Made Millionaire, the service that features a real-money, set-and-forget portfolio of just eight holdings. Our high-quality, deeply discounted lineup includes a clutch of world-class mutual funds, four companies we believe have the potential to wallop the market, and a high-octane ETF.

Ready-Made Millionaire will reopen to new members later this week. If you'd like to learn more about the service, click here to get the inside scoop on a portfolio that we think is well-positioned to take advantage of the rally to come. You'll also be able to snag a free copy of our 11-Minute Millionaire special report.

Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire service and doesn't own any of the securities mentioned. Google is a Motley Fool Rule Breakers selection. Bank of America is an Income Investor choice. UnitedHealth is a pick of both Stock Advisor and Inside Value. The Motley Fool owns shares of UnitedHealth. You can check out the Fool's strict disclosure policy by clicking right here.


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