Whacked-Out Stocks, Great Opportunities

We find ourselves in the midst of a ferocious bear market, a frightening recession, and a huge financial crisis. Amid all these fears, many stocks aren't trading on fundamentals; their prices instead reflect nothing but pessimism.

As illogical and daunting as it may sound, this can actually be a blessing -- and a guarantee of outsized long-term returns -- for smart, calm, diligent investors.

You're kidding, right?
I have been an Urban Outfitters shareholder for quite a few years now. I even held on to the stock through the turbulence that followed its serious fashion misstep in 2006. Urban Outfitters needed to coax droves of customers back through its doors, and it pulled off that feat with flying colors. Its stock recovered, surging to $38 a share at one point in the past year.

Last I checked, Urban Outfitters shares were trading at about $17 per share, near the level the stock hit in 2006, when the retailer was having real problems with its actual business. The stock's beaten down again now, but the problems with its business are nowhere in sight.

Urban Outfitters has done remarkably well this year despite the gloomy consumer spending environment, growing earnings 31% last quarter. Yet its shares have gotten whacked again. This time, however, they're simply getting spanked along with the broader market. (Admittedly, a line of legalese in its most recent 10-Q apparently spooked investors a bit, too.)

With a price-to-earnings ratio of 13 -- insanely low, when you consider that analysts expect 20% growth over the next five years -- Urban Outfitters is a good example of a stock whose fundamentals have gone out the window. Its share price more reflects pessimistic psychology than any realistic assessment of operational strength or growth. It's a quality stock that's been beaten down simply because it's part of a suffering industry, even though Urban Outfitters' actual performance has been an outlier in these terrible times.

For savvy investors, this type of situation spells opportunity.

Taken to the woodshed
Concerns about the financial crisis, the recession, and their effects on consumer spending are whacking stocks across the board. Check out just a few of the stocks that have hit new 52-week lows as of this writing:

* Data from Yahoo! Finance as of Feb. 12, 2009. All stock prices at market close on Feb. 12, 2009.

Severely beaten-down stocks are probably not unfamiliar to you; precipitous drops in stock prices and single-digit price-to-earnings ratios are common these days. Buy-and-hold investors know that such across-the-board drubbings create great opportunities to snap up bargains.

Of course, investors shouldn't be arbitrarily snapping up stocks just because they recently hit 52-week lows, although such lists are a good place to start coming up with ideas.

After all, we are in a dangerous economic climate, and some companies do face real risks to their businesses. Investors must tread carefully. For example, there are good reasons why Zion's getting taken to the woodshed. It's a financial company, and the current economic crisis is making it very difficult for investors to tell the viable banks from the hopeless ones, even if the government is throwing money at some financial companies.

Opportunities abound when so much pessimism is at hand, but investors must choose their stocks with great discrimination.

A whacked-out but wise stock shopping list
My dream stocks these days, like Urban Outfitters, are great businesses with smart management teams, plenty of cash on their balance sheets, and little or no debt.

Two such names that come to mind are Costco (NASDAQ:COST) and Dolby Laboratories (NYSE:DLB). Both have strong brands, growing businesses, and superb balance sheets, and are led by dedicated and solid management. Not coincidentally, they're both recommendations of Fool co-founders David and Tom Gardner's Motley Fool Stock Advisor service, which is currently beating the market by 30 points.

To see what other stocks David and Tom are recommending today, simply click here for a free 30-day guest pass to Stock Advisor.

Nothing wacky about great opportunities
These are unquestionably scary times, but with the proverbial blood running in the streets, investors have a great opportunity to seek out high-quality stocks that will survive and thrive over the long haul. Making careful choices of stock prices that are fundamentally out of whack is a great way to build an excellent long-term portfolio.

This article was originally published on Jan. 17, 2009. It has been updated.

Alyce Lomax owns shares of Urban Outfitters. Portfolio Recovery Associates is a Motley Fool Hidden Gems recommendation. Dolby Laboratories, Mobile Mini, and Costco are Stock Advisor selections. Costco is also an Inside Value selection. The Fool has a disclosure policy.