5 Slam-Dunk Stocks

Almost every day, like clockwork, I get bombarded by about a dozen pieces of junk email. The Viagra solicitations and Nigerian money-laundering scams are deleted the instant they hit my inbox.

Out of sheer curiosity, though, I occasionally take a second to read one of the penny-stock sales pitches -- you know, the ones touting some thinly traded Pink Sheets company with dubious credentials.

Invariably, the hucksters behind these "pump and dump" schemes like to point out a random catalyst that they claim will push the stock sharply higher within the next few days.

And sometimes, they're exactly right.

This one is "ready to run"
Well, let me clarify that.

Sometimes, the stocks they push will indeed soar over the next day or two, but the run-up seldom has anything to do with the company itself but rather with an influx of "buy" orders from those who bought into the hype.

In fact, the very same stock (which will remain unnamed) that was pitched to me over the weekend is up more than 40% this morning on a staggering 25 times average daily trading volume. Yet there is absolutely no discernible news to explain the rapid advance.

If this particular case follows past precedent, then the pumpers could soon cash out their ill-gotten gains, leaving those they've duped to fend for themselves when the shares inevitably come crashing back down.

Over the years, the Fool has done its part to warn investors of those attempting to prey on the uninformed. In fact, my colleague Tim Beyers (who must be on the same spam list as I am) has called out these manipulative, slick-talking salesmen on more than one occasion.

However, let's tackle this problem from another angle. Those who profit from this unscrupulous practice do so only because the allure of easy "can't-miss" gains is so tempting.

Some would urge investors to resist that temptation, but I say to channel it instead in a more productive direction.

Not too good to be true
As we all know, there are simply no guarantees when it comes to stock investing. However, that should never stop us from searching for the next best thing.

By that, I mean those select few stocks whose potential returns are strong to the upside but limited on the downside. And isn't that what a slam-dunk is all about -- putting easy gains on the scoreboard with very little risk of shooting an airball?

Such opportunities are rare, but they can be found with some digging -- though usually not on the Pink Sheets or in penny-stock spam emails.

To a certain extent, stock performance is a function of how well a firm lives up to its expectations. So to find these risk/reward mismatches, just look for sharply undervalued companies where the bar has been set extremely low.

And if these same firms also happen to boast healthy free cash flows, durable competitive advantages, and a dominant position within their respective industry, even better.

Each of the companies in the table below fits the description:

He shoots. He scores!
Using the consensus earnings growth rates to calculate fair value, these stocks look extremely undervalued -- 25% or more in each case, which sounds a little too good to be true for well-covered stocks like these. Obviously, the market has its reasons for the difference between the implied versus consensus growth rates. Perhaps Wall Street believes eBay overpaid for its acquisition of Skype, which is still experiencing sizable start-up losses.

Whatever the case may be, the table nevertheless shows that as long as these firms can outpace their implied growth rates over the next five years, then they're currently undervalued -- though everyone will always quibble over just how much so.

Let's look at one example a little more closely. Money-transfer giant Western Union, for example, churned out approximately $1 billion in free cash flow last year. Assuming that total marches ahead at roughly the same 13% pace as Wall Street's five-year earnings growth outlook (dropping to 8% the following five years and 3% thereafter), a scaled-down discounted cash flow model yields an approximate intrinsic value of $33 per share.

However, at the current price of $22, the implied five-year growth rate baked into the stock is closer to 6% -- a hurdle that Western Union should be able to tiptoe over. Because the company is already trading at a discount, any bad news should elicit a relatively mild shareholder response -- as opposed to the backlash that a more richly valued stock might see.

And while that safety net will help cushion any losses when times are tough, it won't hold back the shares if things go according to plan. In fact, the company only needs to converge with its fair value (not surpass it) to yield impressive gains of 30%-plus for shareholders.

Best of both worlds
Even at its best, investing carries plenty of uncertainty. However, those who target undervalued stocks often have far less to fear when it comes to the unknown.

In many cases, bad news or disappointing results that might sting a pricier company (where expectations run high) will bounce harmlessly off one already trading at a discount.

Fortunately, safety and growth aren't always mutually exclusive. Contrary to popular belief, value stocks have actually outrun growth stocks over the long haul.

For those who want to minimize potential losses while still capturing all the upside potential that the market has to offer (and let's face it, who doesn't?), we invite you to visit Motley Fool Inside Value and look around.

Inside Value advisor Philip Durell and his team are always probing for the next slam-dunk opportunity, and they pull the trigger only on proven, well-managed companies trading at just pennies on the dollar. To date, the portfolio has racked up an average gain of 21%, outscoring the S&P 500 by 6 percentage points.

Western Union is just one of around 60 stocks that have already made the cut. To see the rest, click here and join us free for the next 30 days.

Fool contributor Nathan Slaughter really needs to install a better spam filter. He owns shares of eBay and Western Union. eBay and Shuffle Master are Stock Advisor picks. Western Union is a Motley Fool Inside Value choice. The Fool has a disclosure policy.