Am I the only one who's freaked out by the disconnect between mortgage-backed securities (MBS) and the stock market? Moody's (NYSE: MCO), Fitch, and Standard & Poor's are doing their best soccer-hooligan impressions, trampling hedge funds in their fervor to downgrade these securities, but the stock market isn't paying attention.
Sure, some of the companies directly in the path of the crowd -- like American Home Mortgage (NYSE: AHM), Beazer Homes (NYSE: BZH), and Bear Stearns (NYSE: BSC) -- have taken a beating. That's not a big surprise -- one wouldn't expect lenders, builders, and MBS hedge funds to outperform during a housing bust. But what is surprising is that the overall market was quite recently still hitting highs.
It's barely conceivable to me that this housing bust will stay contained in the housing and lending sectors. It's far more likely that the contagion that Wall Street claimed would only affect subprime -- which has started hurting Alt-A as well -- will poison the other parts of the economy, too.
Storm preparation
So now is the time to make certain that your portfolio can withstand a storm. Do this by focusing on stocks that don't just have the potential for excellent returns, but also can protect you on the downside. To get the best of both worlds, you should be looking at value stocks.
Value stocks are companies that are trading for less than their fair value. Since stocks generally don't fall much below their intrinsic value, cheap businesses provide protection in choppy markets. And, when they bounce back to their fair value, they can provide great returns as well. I'd focus on cheap stocks that are unlikely to be directly affected by the housing contagion.
A cheap stock I'm not buying
Take Lowe's (NYSE: LOW), for example. It's the second-biggest home improvement retailer, boasting better than 6% net profit margins -- excellent for a retailer. Analysts expect it to keep growing at close to a 15% rate for the next five years. It shows a superior return on equity of nearly 20%. Its balance sheet is solid -- a bit of debt, but less than 1/10th of its annual revenue. Even in the worst housing bust, Lowe's is unlikely to go out of business.
Even better, the stock's trading at a cheap forward price-to-earnings ratio (P/E) of about 12.
But I'm still not buying. It's not that I'm worried about losing money, it's just that I have a hard time imagining Lowe's skyrocketing until the housing market starts to recover. I also don't have a great deal of confidence in forward estimates amid a housing bust.
Instead, I prefer to wait until everyone absolutely loathes the stock before buying. That's when Lowe's will have the most upside potential.
A cheap stock that's worth buying
Companies like Aetna (NYSE: AET) are far more attractive to me right now. It's in the health insurance industry -- a niche unlikely to be directly affected by housing. It too boasts strong 6.5% net margins, better than the 5% average in its industry. The business has a 16% projected growth rate and a good 17% return on equity. Aetna's market is more crowded than Lowe's, but Aetna is large enough to compete against the big boys.
Aetna is marginally more expensive than Lowe's, with a forward P/E of 14. But there's far less chance that investors in Aetna will see their stock tick downward whenever the latest talking head says how surprised he is that the housing market still isn't recovering.
In other words, investors in Aetna get the upside of value investing with less headline risk.
Does value investing work?
Value stocks are great in theory, but how are they in practice? Well, our Motley Fool Inside Value newsletter exclusively recommends extremely undervalued stocks. We've been around for three years, and are beating the S&P 500 by six percentage points.
What's more, the value philosophy has proven its mettle when it comes to minimizing losses. We've made a total of 72 recommendations. Of those, the 10 worst picks have an average loss of 13%, with only two of the 72 picks losing more than 15%.
In contrast, the 10 best picks have averaged a 97% return, led by MasterCard's whopping 275% return.
The Foolish bottom line
These stocks have yielded huge gains with low risk. But the key was focusing on value -- buying these businesses for far less than they were worth. If you're looking for ideas, Inside Value has 10 recommendations trading at less than 75% of their fair value, and three superb stocks going for less than 65%. You can read all about them with a free trial.
Fool contributor Richard Gibbons is a fast machine who keeps his motor clean. He does not have a position in any of the stocks discussed in this article. MasterCard is an Inside Value recommendation. Moody's is a Stock Advisor pick. The Motley Fool has the best darn disclosure policy that you've ever seen.
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