Your Best Chance to Profit in 2010

If, after 2008, you still expect the stock market to fund your retirement, most people probably consider you a few congressmen short of a bailout. (Zing!) Yes, it was tough being openly optimistic after a year in which every bull became a steer.

But there are a few perks -- like profiting from buying stocks at what could be some of the best prices you'll ever see.

A brief history of 2008
2008 was a fantastic demonstration of what happens when, in a highly leveraged world, everyone needs liquidity at the same time.

Anyone who borrowed to buy mortgage-backed securities needed cash as mortgage values plummeted. Investment banks like Morgan Stanley (NYSE: MS  ) needed cash as the mortgage-backed securities on their books began to fall. Retail banks like Citigroup (NYSE: C  ) needed cash to maintain their capital ratios as defaults escalated. AIG needed cash to balance its losses in credit default swaps. Hedge funds needed cash to fund redemptions and reduce leverage as assets declined.

The problem is, when everyone needs cash, the only way to get it is to sell off assets. And that's what investors did, dumping almost every asset class with the exception of ultra-safe Treasuries. The stock market took it on the chin.

An overreaction
That's not to say that the market collapsed simply because everyone cashed out. The problems in our economy are real. We've seen huge bankruptcies, the unemployment rate has risen to around 10%, and consumer confidence is low.

But the carnage in the market isn't limited to the shaky companies that are likely to suffer the most. The S&P 500 contains the biggest, most successful, and most stable businesses in America. Yet despite the recent market run-up, more than 68% of the companies in the S&P 500 are down from the start of 2008. Some 10% lost more than half their value!

Certainly, deteriorating business prospects are responsible for some of that drop. But based on valuations, it seems likely that stock investors sold because they had to. Like everyone else, they needed the cash.

And that's a really great thing if you're not one of Wall Street's forced sellers, because it means that despite the broader market run-up in 2009, at least some of those companies remain deeply undervalued -- for now.

The sweet spot
Large-cap value stocks could be the best way to exploit this opportunity. I'm not just talking about slow-growing companies trading at low single-digit earnings multiples, but also compellingly cheap growth stocks.

For instance, these days, the universe of large-cap value stocks includes Microsoft (Nasdaq: MSFT  ) . Microsoft has huge barriers to competition, nearly $30 billion of net cash on its balance sheet, a 12% estimated annual growth rate going forward, and it's trading for about 16 times earnings. At these prices, Microsoft is a large-cap value stock.

So why are large-cap value stocks a great investment these days? Not because these stocks are certain to outperform the other categories under all circumstances, but because they present the ideal trade-off between risk and reward in these troubling times.

While there's a good chance that the economy will continue showing signs of life this year, there's a possibility that things will get even worse. When you're betting your retirement, you should own businesses that can survive the worst-case scenario.

Low risk, high reward
Generally, large-cap stocks fit that criterion. They have the most stable cash flows, the most well-known brands, the greatest economies of scale, and the best chance of recovering from mistakes.

Would you put your money on Intel (Nasdaq: INTC  ) to withstand a depression, or Advanced Micro Devices (Nasdaq: AMD  ) ? Would you bet on Pfizer (NYSE: PFE  ) or Dendreon (Nasdaq: DNDN  ) ? These two examples may be hyperbolic, but powerhouses like Intel and Pfizer are far more likely to survive than companies with smaller moats. The larger companies have financial clout, economies of scale, and proven, winning business models.

In normal times, you'd really have to pay up for these sorts of dominant companies. But thanks to forced selling from investors struggling to raise cash, right now you can still find some excellent businesses extremely cheap.

What's more, thanks to the poor economy, the earnings of these powerhouse companies have been depressed this year, which means that their normalized earnings multiple is even more compelling. Large-cap stocks are still cheap, and I believe they will offer superior returns over the next few years.

The Foolish bottom line
Of course, you still have to be careful -- as 2008 has shown us, you can't just throw a dart at the S&P 500 and expect to strike it rich. You still need to pay attention to balance sheets and monitor how much cash companies are bringing in during these troubling times.

But if you're alert, you can find the stocks right now that will pay for your retirement. So now is a good time to start buying large-cap value stocks. If you're interested in ideas, our Motley Fool Inside Value team has identified the dirt-cheap stocks that we think offer the most enticing combination of safety and upside potential. You can read our complete analysis with a 30-day free trial.

Already a member of Inside Value? Log in at the top of this page.

This article was originally published Jan. 8, 2009. It has been updated.

Fool contributor Richard Gibbons knows all too well the pain of becoming a steer. He owns shares of Microsoft. Intel, Microsoft, and Pfizer are Inside Value recommendations. The Fool owns a covered strangle on Intel. Motley Fool Options recommended buying calls on Intel and diagonal calls on Microsoft. The Fool's disclosure policy wears a large cap to avoid sunburn.

Read/Post Comments (2) | Recommend This Article (20)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 01, 2010, at 7:21 PM, getrickqk wrote:

    If you have a lot of money and a lot time to wait for your investment to grow, investing in large, stable companies like Apple, Intel or Microsoft is next to a sure thing to make money but taking a chance with small capital of a couple hundred bucks can yield over 1000% returns on taking a big chance on small companies like Dendreon, Human Genome Science and others.

  • Report this Comment On April 01, 2010, at 7:28 PM, getrickqk wrote:

    Yes, it's a safe investment path to stay with large companies like Apple. It took me 2 years to accumulate 194 shares, buying every month until I finally sold it @$198, making over $5000. But last year I bought 3000 shares of Dendreon at $3/share and to date the unrealized gains is over $102,000! Yes you can say, I was just lucky but no matter I still made over 20X more than my Apple investment!

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