Dirt Cheap Dream Stocks

Let me take you back to 1993. IBM had posted an $8 billion loss, and its share price was in free fall. Technology was changing the world, and IBM wasn't adapting. It was losing hardware business to Dell and Hewlett-Packard, and losing software sales to Microsoft and Oracle. Wall Street panicked.

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 endured the hysteria in 1993 were rewarded with outsized profits; an investment made during the lean years would have yielded 870% returns. That's right. This classic turnaround, once considered at death's door, gave investors a nine-bagger.

Wouldn't you love to find (and, more importantly, invest in) the next IBM? Especially now, when many excellent companies have seen their share prices plummet by 30% or more in a matter of weeks?

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.

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. Fears of large-scale litigation drove the stock price down to bargain prices -- but those fears were overblown.

IBM, J&J, and Altria have all 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.

Company

Undervalued
Date

Return on
Investment Since

IBM

August 1993

868%

J&J

March 2000

92%

Altria

April 2003

243%

Prices are split- and dividend-adjusted and include spinoffs, if any. Data from Yahoo! Finance.

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 proven 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, value stocks returned 11% per year; the S&P returned 10.2%; and growth stocks, 8.8%.

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 strong 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. Listen to ideas from others (I frequent our wonderful Foolish community of message boards). Scour 52-week-low lists, which today seem like a who's-who of blue-chip names: Texas Instruments (NYSE: TXN  ) and Boston Scientific (NYSE: BSX  ) are two intriguing companies that recently hit a yearly low.

Run the numbers via stock screens. For instance, below I've provided you with four companies that have been beaten down in the past year but that have some attractive features:

Company

Market Cap

Return on Capital*

P/E*

One-Year Price Change

Walgreens (NYSE: WAG  )

$23.0 billion

16.3%

11.7

(40%) 

Genuine Parts (NYSE: GPC  )

$5.3 billion

16.1%

10.6

(31%) 

Harley-Davidson (NYSE: HOG  )

$7.0 billion

17.9%

7.8

(39%) 

Omnicom Group (NYSE: OMC  )

$9.6 billion

15%

9.7

(41%) 

*Last 12 months. Data from Capital IQ, a division of Standard & Poor's.

I'm not recommending these companies per se -- they'll require further research and due diligence on your part -- but their operational efficiency, mixed with their current multiples, warrants a close look.

When searching for juicy value bargains, I calculate a stock'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. Although 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.

Or, you can be my guest at Inside Value for 30 days 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 co-advisor of Motley Fool Inside Value. He owns shares of Dell but of no other companies mentioned in this article. Microsoft and Dell are Motley Fool Inside Value recommendations. Genuine Parts and Johnson & Johnson are Income Investor selections. The Motley Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (45)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 14, 2008, at 4:26 PM, pilot50 wrote:

    It is truly amazing how you keep on shoving Harley Davidson (HOG) down our throat. You have been recommending this stock for almost two years now as the stock continually, and I mean CONTINUALLY declines.

    Not even a peep out of you in apologies for making rash stupid investment statements. Look at those that took your advice and are sitting on half value or less in theri stock. This also has nothing to do with the recent immediate financial problems either. It started months ago. Even now, as we see declines in toys, or higher ticket items, obvious market slowdowns, financing arena problems for them, you still ask us to put more in it, in the "hopes" it will turn around.

    Yes someday it might, but hardly worth sitting for ten years on this stock as it goes from 28.00 to maybe 38.00.

    I really find your idea of comparing IBM and J&J and their turnarounds to HOG almost laughable. Totally different market reach, ideas, concepts, products and delivery.

    It is this type of foolish comparisons that you dream up that gives you guys your last name.

    Robert

  • Report this Comment On October 14, 2008, at 6:20 PM, TMFAdmiral wrote:

    Hi Robert,

    I can understand that you might not like HOG as an investment but this is the first time I have mentioned it anywhere as any time I looked at it I thought it was overvalued.

    The Motley Fool is not one amorphous body with a single collective opinion on any company. Analysts, advisors and writers frequently differ and in fact are encouraged to do so

    Also I wasn't making a direct comparison with JNJ anywhere I could see. The whole premise of the article is to buy stocks when they are cheap and HOG is cheap for a great brand if you look long term. If you look short term may be not. You will also note that I specifically said that I'm not recommending

    "'m not recommending these companies per se -- they'll require further research and due diligence on your part -- but their operational efficiency, mixed with their current multiples, warrants a close look."

    With the stock now down to the $25 to $30 range from its November 2006 high of $75 it is certainly worth a look. That price already anticipates a recession and lower earnings for the next couple of years but with a P/E of 8, the company has a strong cash position and produces positive free cash flow.

    Best Regards

    Philip

  • Report this Comment On October 15, 2008, at 2:37 AM, PhileasFogg wrote:

    I have to agree with Philip about HOG. Like him, I think HOG has now reached a point where nibbling is warranted.

    I first noticed HOG when Harindra D'Silva, who runs Analytic Investors, recommended shorting it in the Dec-06/Jan-07 issue of Forbes magazine, in the 'champion investors' section. Mr DaSilva had just been named the best stockpicker by Forbes for 06, so he was invited back for the 07 contest. And, he was dead right; the stock declined into the high 40s by years end. it's down about 39% in the past 12 months, and , as Philip said, is trading at about 8-9 times next year's earnings. Perhaps the rebounding dollar will hurt because HOG does sell a lot of machines overseas. But after 2 straight years of horrific declines, I can see HOG stabilizing very soon.

    One smart approach maybe to buy half the number of shares you would like to own and sell puts for the other half at a lower strike price, say $26 or $25.

    cheers!

  • Report this Comment On October 22, 2008, at 4:49 PM, muchohucho wrote:

    I don't fully understand how any stock screening or research into company numbers is going to be of any use right now. There just seems to be so much global uncertainty. Six months ago, who would have though the dollar would be trading where it is now, or oil selling in the 60s. IF someone told me oil would be 68 dollars a barrel in July I would have though they were loonie toons. Its impossible right now to say if a company is cheap, even it is selling for less than book value and has more cash per share than its sellling price. No one knows, that's the point, and the main reason why the market is tanking.

  • Report this Comment On January 05, 2009, at 3:32 AM, Mary953 wrote:

    An exceptional benefit of your CAPS community is the opportunity to bounce ideas and information back and forth. The debate provides excellent points and knowledge that might not otherwise be available. For just such debate regarding HOG, try this particular post: http://caps.fool.com/Blogs/ViewPost.aspx?bpid=125369&t=0...

  • Report this Comment On February 24, 2009, at 6:42 PM, aascheiby wrote:

    When you mention Gerstner at IBM, don't forget the Drucker was behind his actions.

  • Report this Comment On August 06, 2009, at 6:45 AM, Joe56Corr wrote:

    I followed Warren Buffett into this stock (HOG) and I've made nearly 50% and I'm holding, also GS.

    This was at a time when the herd were baying that Buffett had lost his touch and the world was ending.

    Seems people will be negative when things are cheap and when they are expensive so don't listen to the herd.

    By the way when swine flu broke, HOG shares fell big time, shows you how the herd stampedes off cliffs.

  • Report this Comment On August 06, 2009, at 9:04 AM, vishtr wrote:

    How the stock (HOG) is valued, I can't say, I haven't performed DD. However, it is a company that I would say will eventually bounce back if undervalued. I took the 5 hr drive from Maryland to CT last weekend and saw at least 50+ Harleys on the road, and not in a group either. People still, and I think at this point probably always will, want to buy their product.

  • Report this Comment On November 23, 2009, at 4:14 PM, Bays wrote:

    pilot50,

    Give your head a shake.

  • Report this Comment On November 23, 2009, at 4:15 PM, Bays wrote:

    pilot50,

    Give your head a shake.

  • Report this Comment On December 13, 2009, at 10:28 AM, mrspiffy1 wrote:

    If you owned any of those over the past 2 years.. congrats...you lost $$$. AND you didn't get a whole lot of yield to take the insult away from injury.

    http://yieldpig.blogspot.com/

  • Report this Comment On December 15, 2009, at 10:44 AM, Tuxster12345 wrote:

    As of today, I can't see how HOG is undervalued.

    The stock's price-to-owner earnings ratio is about 28 and its enterprise value-to-free cash flow ratio about 23.

    I based these figures on the company's 12-month trailing owner earnings and free cash flow numbers.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 752019, ~/Articles/ArticleHandler.aspx, 8/30/2014 10:31:52 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...