Investors today face a dilemma. With the Dow still down nearly 40% from its peak, top investors like Chuck Acre, Whitney Tilson, and Warren Buffett keep reminding us that stocks are cheap.
On the other hand, every day, newspapers report another round of layoffs, and bleak headlines leave us all wondering how low stocks could go.
So if you think today's an utterly lousy time to invest, well, I certainly can't blame you.
That said ...
Do you remember the Internet bubble? I sure do. When the Great Bubble burst in 2000, I saw my portfolio fall directly into the commode -- down 40% in the space of a few months.
See, back in 2000, I bought into the worst of the worst tech stocks. The overhyped Palm IPO. The overpriced Cisco (NASDAQ:CSCO). The soon-to-be-bankrupt Winstar. And I paid the price for my mistakes. But as the market slowly turned around, I eventually recovered my losses -- and then some.
Of course, the financial crisis we are facing today is far more widespread and threatening than the Internet bubble was. Nevertheless, over the course of time, I learned that building real wealth consists of three simple, timeless steps:
- Earn as much as you possibly can.
- Save as much as you possibly can from what you earn.
- Invest those savings.
Working as many as five jobs simultaneously, my wife and I scrimped and saved. We cut corners. And no matter how much we took home from work, we strove (not always succeeding, I admit) to put away at least a third of our income for a rainy day. Then we invested it.
Invested in what?
I set out to describe the investment philosophy I learned from Motley Fool co-founder Tom Gardner. The result was a 2004 column I titled "7 Steps to Finding Gems." You can read it just by clicking through the link, but here's the dime tour:
I invested in companies that:
- Had superb management.
- Generated significant free cash flow.
- Grew that cash flow quickly.
- Traded for cheap prices.
How low? To keep it simple, I like to see companies selling for a price-to-free cash flow-to-growth (P/FCF/G) ratio of less than 1.0. It's really a fancy-pants version of the PEG ratio, popularized by legendary former Magellan Fund manager Peter Lynch. I prefer free cash flow over GAAP earnings as a measure of profitability; while GAAP profits may be good enough for the SEC, I believe free cash flow is a more reliable indication of financial health.
Now here's the best part
It was easy finding great companies that fit this criterion after the Internet bubble burst. But ever since 2005, I've been having trouble finding many stocks selling for as cheap as I'd like to pay -- until now.
Thanks to the Great Sell-Off of '08, stocks finally offer investors today the chance to earn the kind of profits I reaped back in 2001-2005. When I ran one of my favorite stock screeners in search of bargains last week, several likely suspects popped right up, each trading at or near my target valuation:
|
Company |
P/FCF |
P/FCF/G* |
|---|---|---|
|
GameStop (NYSE:GME) |
12.4 |
0.76 |
|
Sigma Designs (NASDAQ:SIGM) |
9.5 |
0.61 |
|
Force Protection (NASDAQ:FRPT) |
10.5 |
0.53 |
|
Jones Lang Lasalle (NYSE:JLL) |
5.9 |
0.37 |
|
Alpha Natural Resources (NYSE:ANR) |
6.35 |
0.33 |
|
Allied Irish Banks (NYSE:AIB) |
0.45 |
0.02 |
Data from Finviz.com and Yahoo! Finance.
*Based on consensus five-year earnings growth estimates.
A word of warning ...
Screens like this one can help you to find bargains, but they've got their limits as well. Take the apparent "cheapest stock on the list" -- Allied Irish Banks. With a price-to-free cash flow-to-growth ratio of 0.02, your first instinct might be to yell: "Hurray! They're practically giving it away!"
Alas, they aren't necessarily. Allied Irish's presence on this list offers a case study in how not to use this screen. Specifically, do not use it to pick banks. By their very nature, banks cannot be valued on their "free cash flow." Allied Irish may or may not be a good stock, but valuing it requires a great measure of due diligence since banking today is such an incredibly complex and largely unpredictable industry.
... and one of hope
The good news is that even if you don't choose to invest in banks, this market offers bargains aplenty. If you could use a little help finding them, why not give Motley Fool Hidden Gems a whirl? The Fool's premier small-cap investing newsletter has walloped the S&P's returns for nearly six straight years now by seeking just such value propositions. Take a free trial, and you can sneak a peek at the top 10 stocks we recommend buying today.
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This article was first published March 10, 2009. It has been updated.
Fool contributor Rich Smith does not own shares of any company named above. Jones Lang is a Hidden Gems recommendation. Sigma Designs is a Rule Breakers selection. GameStop is a Stock Advisor pick. Allied Irish Banks is a Global Gains selection and a Fool holding. The Motley Fool has a disclosure policy.
