Hunting Fallen Angels

Value investing is the only strategy proven to beat the market over the long term. Consider: If you'd invested $1,000 in value stocks in 1968, you would now hold $35,000 -- compared with $18,000 if you chose growth stocks or a mere $8,500 if you'd picked the S&P 500. And if you don't think that's true, just look at how the value ethos has run roughshod over the market. From Warren Buffett and Charlie Munger at Berkshire Hathaway to Bill Ruane at Sequoia Fund to Rick Guerin at Pacific Partners, the disciples of Graham and Dodd have proved time and time again that hunting for value works in every kind of market.

Let's get hunting
There are six places I hunt for value for my Motley Fool Inside Value subscribers. They are:

  1. Wounded elephants
  2. Cyclicals
  3. Former glamour stocks
  4. Fallen angels
  5. Bankruptcy survivors
  6. Stealth stocks

Great names, to be sure. And they reap great rewards as well.

Today's lesson
Fallen angels are companies that have been accused of fraud or deception, or are targeted by investigators. The danger with hunting fallen angels is that they never stop falling, but you can often identify turnarounds in the making by keeping your eyes peeled for a change in management, an improving balance sheet, or strong free cash flow.

At Tyco (NYSE: TYC  ) , executives were apparently looting the company, and everyone was jumping ship. The stock slumped to $10 and change, but with a new board, new management at the helm, and tremendous cash-producing assets, Tyco was a steal. (Repeat the fallen angel mantra: change in management, improving balance sheet, strong free cash flow.) And although free cash flow can get low because of one-off costs like fines or other penalties, always keep an eye on cash from operations -- that's the real deal. Today, Tyco stock trades around $28 -- a nearly 300% gain from its lows.

Foolish final thoughts
What fallen angels am I waiting to show signs of life? I'll tell you: Fannie Mae (NYSE: FNM  ) , AIG (NYSE: AIG  ) , Merck (NYSE: MRK  ) , and Marsh & McLennan (NYSE: MMC  ) . Companies that could prove to be tremendous bargains going forward because the market almost always overreacts on the downside, just as it does on the upside.

If you want to stay updated on the angels that the market may be offering up, consider a 30-day free trial to my Inside Value newsletter. We hunt down two market-beating values every month and are helping subscribers beat the market by nearly eight percentage points. Click here to learn more.

Ask the masters: Value works. Happy hunting!

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This is a revised version of "Hunting for Value," which was originally published on Nov. 18, 2004.

Philip Durell is the analyst for the Motley Fool Inside Value newsletter. He does not own shares of any stock mentioned.Fannie Mae is an Inside Value recommendation. Merck is a Motley Fool Income Investor recommendation. The Fool has a strictdisclosure policy.


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