Dirt Cheap Dream Stocks

Let me take you back to 1993. IBM had posted an $8 billion loss, and its share price was in freefall. Technology was changing the world, and IBM wasn't adapting. It was losing hardware business to Dell and Hewlett-Packard (NYSE: HPQ), and it was losing software sales to Microsoft and Oracle (Nasdaq: ORCL). 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 -- whose previous leadership stints were at American Express and RJR Nabisco -- 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 endured the hysteria in 1993 were rewarded with outsized profits; an investment made during the lean years would have yielded more than 1,100% returns. That's right. This classic turnaround, once thought to be on death's door, gave investors a 12-bagger.

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

Yeah, we all would, and I think we're smart to aim high. That's what we search for here at our Motley Fool Inside Value investment service. And history shows us that dream stocks -- like IBM -- occasionally become available on the market. For 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 invested capital (ROIC); 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 at least 10 or 20 years. Those dream stocks are like perennial plants, coming back year after year and multiplying along the way, without fertilizer or sprinkler systems.

And, believe it or not, dirt cheap dream stocks are available right under your nose. By snooping around the market, it's possible to find underappreciated stocks that Wall Street has unfairly penalized. Analysts are bearish. The public is selling.

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

Take, for instance, Johnson & Johnson. 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. This is the same type of panic that's notably dogged Merck (NYSE: MRK) and Bristol-Myers Squibb (NYSE: BMY) in recent years.

Also consider Altria, which, in the spring of 2003, was reeling from lawsuits, increased taxes, and discount competitors in its Philip Morris USA unit. Bankruptcy talk was in the air. While fears of large-scale litigation drove the stock price down to the mid-$20s, I valued it closer to $52.

IBM, Johnson & Johnson, and Altria have regained focus and 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 and experiencing deflated share prices as a result. 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. History has proved that, over time, the value approach gives investors the potential to hit home runs. In an article last year, I cited an Ibbotson Associates study showing 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 (since September 2004), our recommendations in Inside Value have continued the trend: Our picks have gained 24% on average, versus 23% gains for the S&P 500.

Mimic the masters
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 ROIC and long-term competitive advantages.

Follow in their paths, and the approach is simple: Search for unloved companies. Read the newspapers to search for castaways. Scour 52-week-low lists -- the market's recent sell-off has dropped many established companies to new lows, including Rite Aid (NYSE: RAD) and Toyota Motor (NYSE: TM) (The Wall Street Journal is a great resource for such lists). Listen to ideas from others (I frequent our wonderful Foolish community of message boards). Run the numbers via stock screens.

When I find such companies, I calculate the company's fair value based on my discounted cash flow analysis. Then it's just a matter of sitting back and waiting patiently.

I wait for the actual stock price to slip below the fair value estimate, giving me a margin of safety. When I spot such a bargain, I jump in ... and I patiently wait again, 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
Don't be turned off by terms like solid and patient. Though value investing isn't a get-rich-quick scheme, we're giddy to use descriptors like tremendous or out of this world to characterize our returns.

Sometimes, the down-and-out companies stay down -- and then bow out. Follow the value luminaries and learn the difference.

Alternately, you can be my guest at Inside Value for one full month and get the ideas flowing. You'll receive two stock recommendations per month, as well as full access to every buy report to date. And the first 30 days are on me. There's no obligation. 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 the advisor/analyst for Motley Fool Inside Value. He owns shares of Microsoft and Dell but of no other companies mentioned in this article. Microsoft and Dell are both Inside Value recommendations. Dell is also a Stock Advisor recommendation. The Motley Fool has a disclosure policy.