This Recession Is Gonna Make Me Rich (Again)

Investors today face a dilemma. With the Dow still down more than 30% from its peak, top investors like Chuck Acre, Whitney Tilson, and Warren Buffett keep reminding us that stocks are cheap.

On the other hand, every day, newspapers report another round of layoffs, and bleak headlines leave us all wondering how low stocks can go.

So if you think today's an utterly lousy time to invest, well, I certainly can't blame you.

That said ...
Do you remember the Internet bubble? I sure do. When the Great Bubble burst in 2000, I saw my portfolio fall directly into the commode -- down 40% in the space of a few months.

See, back in 2000, I bought into the worst of the worst tech stocks. The overhyped Palm IPO. The overpriced Sun Micro. The soon-to-be-bankrupt Winstar. And I paid the price for my mistakes. But as the market slowly turned around, I eventually recovered my losses -- and then some.

Of course, the financial crisis we are facing today is far more widespread and threatening than the Internet bubble was. Nevertheless, over the course of time, I learned that building real wealth consists of three simple, timeless steps:

• Earn as much as you possibly can.
• Save as much as you possibly can from what you earn.
• Invest those savings.

Working as many as five jobs simultaneously, my wife and I scrimped and saved. We cut corners. And no matter how much we took home from work, we strove (not always succeeding, I admit) to put away at least a third of our income for a rainy day. Then we invested it.

Invested in what?
I set out to describe the investment philosophy I learned from Motley Fool co-founder Tom Gardner. The result was a 2004 column I entitled "7 Steps to Finding Gems." You can read it for yourself just by clicking through the link, but here's the dime tour:

I invested in companies that:

• Had superb management
• Generated significant free cash flow
• Grew that cash flow quickly, and
• Traded for cheap prices

How low? To keep it simple, I like to see companies selling for a price-to-free cash flow-to-growth (P/FCF/G) ratio of less than 1.0. It's really a fancy-pants version of the PEG ratio, popularized by legendary former Magellan Fund manager Peter Lynch. I prefer free cash flow over GAAP earnings as a measure of profitability; while GAAP profits may be good enough for the SEC, I believe free cash flow is a more reliable indication of financial health.

Now here's the best part
It was easy finding great companies that fit this criterion after the Internet bubble burst. But ever since 2005, I've been having trouble finding many stocks selling for as cheap as I'd like to pay -- until now.

Thanks to the Great Sell-Off of '08, stocks finally offer investors the chance to earn the kind of profits I reaped back in 2001-2005. Running one of my favorite stock screens in search of bargains last week, several likely suspects popped right up, each trading at or near my target valuation:

Data from Finviz.com and Yahoo! Finance.
*Based on consensus five-year earnings growth estimates.

Did I say that was the best part?
Well, check that. Actually, the best part about some of these companies is the part you don't see reflected in the table above. Last month, I warned about how a screen for free cash flow can give "false positives" on apparently cheap bank stocks. But such screens can also turn up stocks that are cheaper than they seem.

Take Apple, for example. With a price-to-free cash flow-to-growth ratio of 0.76, you might think this stock is no better than a middle-of-the-pack contender among these bargain-priced companies. But it's actually about 20% cheaper than it looks.

You see, in addition to the cash flowing in its doors every year, Apple also has a sizeable cash stash already built up. Subtract out the $24 billion in cash that comes with this stock, and the business behind the ticker is actually trading for something like an enterprise value-to-free cash flow-to growth ratio of 0.63.

Foolish takeaway
Would-be Apple sauce-makers call the stock "expensive" at 28 times earnings. But in so doing, they miss the real story twice. First, by relying on reported earnings, they underestimate the cash-generating prowess of the underlying business. Second, they ignore all the cash that Apple has already generated. There's more value here than meets the eye.

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This article was first published March 10, 2009. It has been updated.

Fool contributor Rich Smith owns shares of optionsXpress, which, along with Apple, is a Motley Fool Stock Advisor pick. Nuance and Blackboard are Hidden Gems recommendations. Flir is an Inside Value selection. The Motley Fool has a disclosure policy.