Dirt Cheap Dream Stocks

Let me take you back to 1993. IBM (NYSE: IBM) had 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 losing software sales to Microsoft 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 search for here at our Motley Fool Inside Value investment service. And history shows us that dream stocks -- like IBM -- occasionally become available in 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 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 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 have been unfairly penalized by Wall Street. 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, consumer goods stalwart Procter & Gamble (NYSE: PG). After reaching a 52-week high in January 2000, the company's share price plummeted by more than 50% in less than two months. P&G's shares declined by 30% on March 7 alone. The company had missed earnings and appeared to be disorganized under the new leadership of CEO Durk Jager.

Or how about McDonald's (NYSE: MCD), which bottomed out at $11.97 in March 2003 on fears of mad cow and hoof-and-mouth diseases, dietary and nutritional concerns, and increased competition from the likes of Yum! Brands (NYSE: YUM) and its stable of non-burger offerings? McDonald's shares shot down to about the price of dinner for two at the Golden Arches.

Also consider Altria (NYSE: MO), 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.

P&G, McDonald's, 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	Undervalued price	May 2006 price	Return on investment
IBM	August 1993	$9.19	$82.52	798%
Procter & Gamble	March 2000	$23.56	$56.49	140%
McDonald's	February 2003	$12.13	$35.81	195%
Altria	April 2003	$24.17	$73.38	204%

*Returns are split- and dividend-adjusted. Closing price 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, 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 year, I cited an Ibbotson Associates study that showed 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 year and a half), our recommendations in Inside Value have continued the trend: Our picks are up 14.4%, versus 10.4% 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 ROE 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. 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. And then it's a matter of sitting back and waiting patiently.

Wait for the actual stock price to slip below the fair value estimate, which gives you a margin of safety. 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
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" to describe 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 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 thereafter. Let's go hunting for the nextdirt 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. He owns shares of Microsoft and Dell, but 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 adisclosure policy.