Dirt Cheap Dream Stocks

Let me take you back to 1993. IBM posted an $8 billion loss, and its share price was in free fall. Technology was changing the world and IBM was not adapting. It was losing hardware business to Dell and Hewlett-Packard and software sales to Microsoft (NASDAQ:MSFT) and Oracle. Wall Street was panicking.

But this was a solid company with a long history. It was just three years removed from its most profitable year ever, and although times were tough, new CEO Louis Gerstner had a vision to turn the ship around. Indeed, Gerstner and his new management team came on board and taught that old elephant to dance.

In one of the greatest turnarounds in history, IBM has bounced back -- and then some. Investors who saw through the hysteria in 1993 were rewarded with outsized profits: An investment made during the lean years has yielded a nearly 800% return. That's right -- this classic turnaround, once thought to be on death's door, gave investors a nine-bagger.

So, wouldn't you love to find (and, more importantly, invest in) the next IBM?

Yeah, we all would; I think we're smart to aim high. That's what we do here at the Motley Fool Inside Value investment service. And I'm here to tell you that dream stocks -- like IBM -- occasionally become available in the market. For cheap. Dirt cheap.

Dare to dream ... of big returns
I'm talking about the kind of stock that will help you sleep at night: one that's underpriced and comes with a long-term sustainable advantage over its competitors, a high return on equity (ROE), a sterling balance sheet, loads of cash, consistent dividend payments, a high credit rating, and a history of share buybacks. When I happen upon that kind of company, I want to make it part of my core holdings for 10 to 20 years. You may not believe this, but it's unlikely that I'll ever sell it. Those dream stocks are like perennial plants, coming back year after year and multiplying along the way, without fertilizer or sprinkler systems. In those situations, I'm more inclined to look for further opportunities in the future, maybe two or three years down the road, to add to the position.

How do you find them? No, you don't need to scour the obscure universe of nanotechnology or try to pinpoint the next "can't-fail" dot-com. It's not nearly as complicated as Wall Street wants you to believe. Dirt cheap dream stocks are available right underneath your nose.

By snooping around the market, it's possible to find underappreciated stocks that have been unfairly penalized by Wall Street. Analysts are dumping them. The public is selling. When everyone else runs, my interest is piqued.

To spot a turnaround, I look at specific types of companies: wounded elephants, former glamour stocks, or fallen angels, to name a few. I demand several things from a candidate, including a solid management team, free cash flow, competitive advantages, and attractive tangible assets.

Take, for instance, Sunrise Senior Living (NYSE:SRZ). In October 1999, the operator of senior living services was struggling to digest a bad acquisition. The company was also guilty of overbuilding facilities. Pressure from market leader Manor Care (NYSE:HCR) was mounting, and shares dropped 76% off the previous year. But Sunrise had been in the business since 1981, and its competitive advantages were strong.

Or how about Johnson & Johnson (NYSE:JNJ)? The venerable American brand bottomed out near $30 (split-adjusted) in March 2000 in part because its heartburn medicine, Propulsid, which had $940 million in 1999 sales, was yanked from the market. Fears of litigation drove the stock price down, and rivals such as Bristol-Myers Squibb (NYSE:BMY) looked like safer bets.

Also consider Altria, which, in the spring of 2003, was reeling from lawsuits, increased taxes, and discount competitors pummeling its Philip Morris USA unit. The best-performing stock of the S&P 500 was now nosediving. While fears of large-scale litigation drove the stock price down to the mid-$20s, I valued it closer to $52. (Cigarette competitor British American Tobacco (NYSE:BTI) was suffering a similar fate, before rocketing back.)

Johnson & Johnson and Altria have regained focus and have come roaring back. Investors spotting these stocks would've been handsomely rewarded to stick with such solid companies when others were selling.

The purpose of this table is not to cherry-pick or play rearview mirror tricks. It illustrates the point at which several truly great companies were facing their greatest struggles, leading to deflated share prices. These companies have come a long way -- and their returns reflect that. Ask yourself: Would you have had the guts to buy at the bottom?

Value investors probably would, and history has proved that, over time, the value approach gives investors the potential to hit home runs. In an article last fall, I cited a study conducted by well-regarded research firm Ibbotson Associates indicating that value investing outperformed both growth investing and the S&P 500 from December 1968 to December 2002. During that time period, value stocks returned 11% per year; growth stocks, 8.8%; and the S&P 500, 6.5%.

Over a much shorter time frame (the past 17 months), our recommendations in Inside Value have continued the trend: Our picks are up nearly 10.5% vs. a 7.4% gain for the market at large (as measured by the S&P 500). That includes all our picks, including those I've just made. The eight companies I recommended in 2004 -- which have had sufficient time for the investment theses to materialize -- are up nearly 30% vs. market gains of about 13%. That's the power of patience.

Mimic the masters
That's right, the first step toward those great returns is to follow the trails blazed by legendary investors such as Benjamin Graham and Warren Buffett. In their value approaches, they've searched for unloved companies with solid management, free cash flow, and attractive assets. While Graham was more conservative, Buffett has gone a step further: He'll pay fair value for a great business with high ROE and long-term competitive advantages.

Following in their paths, my approach is simple. To spot the great turnarounds, I constantly search for unloved companies. I read the newspapers to search for castaways. I look for ideas in our wonderful Foolish community of message boards. I run numerous stock screens. And then, for the select companies that make it on my Watch List, I run a series of metrics -- including discounted cash flow (DCF) analysis, which I've conducted thousands of times -- to give me my estimate of a company's intrinsic value.

Once I have the fair value, I sit back ... and wait patiently. I wait for the actual stock price to slip below my fair value estimate, giving me a margin of safety for my investment. When I spot such a bargain, I jump in ... and I again patiently wait, this time for the market to recognize the undervaluation, thereby driving up the price of the stock to levels at or above my intrinsic value estimate.

In short, I seek good deals at great prices. Having a margin of safety allows me to minimize the risk while aiming for solid returns.

Putting it all together
Please don't be turned off by terms like "solid" and "patient." Though value investing isn't a get-rich-quick scheme, we are giddy to use adjectives like "tremendous" or "out of this world" in describing our returns.

Sometimes the down-and-out companies stay down. And then bow out. So how can you differentiate an Enron from a Microsoft, a November 2005 Inside Value recommendation? The stock is up a little more than 10% in the short time since I picked it, but it has plenty of room to run. Or how about PetSmart (NASDAQ:PETM), the leading pet retailer with more than 750 stores? I added PetSmart to my Watch List recently, and I believe it's a story worth watching. The company has grown earnings at 63% per year over the past three fiscal years, but slowed down in the past 12 months. It's been a "story stock," but the share price has retreated to a more reasonable level as of late -- and I'll be watching to see if it falls further.

Why not follow the plot lines of Microsoft and PetSmart along with us? Take a free, one-month trial to Inside Value by clicking here. That's right: The first 30 days are on me, giving you a chance to read all of our back issues and get my rationale for all of my previous recommendations. There's no obligation to subscribe. Let's go hunting for the next dirt cheap dream stock together.

This article was originally published on April 13, 2005. It has been updated.

Philip Durell is advisor/analyst of Motley Fool Inside Value . Philip does not own shares of any company mentioned in this article. Dell and PetSmart are Motley Fool Stock Advisor recommendations. The Motley Fool is investors writing for investors.