This Recession Is Gonna Make Me Rich (Again)

Investors today face a dilemma. With the Dow still down 30% 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 can 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. 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 for yourself 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 cheap? To keep it simple, I sought out 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. Yes, even now that the market has "returned from the dead," bargains still abound. Running one of my favorite stock screeners in search of bargains last week, several likely suspects popped right up, each trading below my target valuation:

Data from Finviz.com and Yahoo! Finance. *Based on consensus five-year earnings growth estimates.

Mirror, mirror, on the wall -- I hope
Screens like this one can help you to find bargains, but they can also lead to overconfidence in false precision. I mean, just look at the chart above. How sure am I that LoopNet is precisely one percentage point cheaper than LG Display?

Answer: Not certain at all. Why, I'm not even sure that Transocean is a better bet than Blackboard -- yet it looks 10 points cheaper.

Investing in value-priced stocks, you see, is a lot like hanging a mirror on drywall -- it's educated guesswork. You take your stud finder. You make your best guess at where the stud's hiding behind the drywall. And you pound in a nail. It's not necessary to calculate dead center precisely -- so long as you hit the stud somewhere, you're golden. (But make darn sure you do hit the stud. Otherwise you're liable to be shopping for a new mirror the next day.)

The good news, of course, is that the prices on these stocks all look pretty solid. Whether one is a slightly better pick than another is largely irrelevant. Why, even if one of 'em comes crashing down, diversifying your investments across a handful should mitigate the damage.

And speaking of mitigation, it never hurts to get a second opinion before you swing that hammer. Personally, I've found it helpful to use a combination of tactics in choosing my own stocks. I run the screen above, then choose from it those stocks that both meet my valuation criteria and have received the Motley Fool Hidden Gems seal of approval. The Fool's premier small-cap investing newsletter has walloped the S&P's returns for nearly six years, and as second opinions go, that's a pretty good recommendation.

Take a free trial of the service now, and you can sneak a peek at the top 10 stocks our Gems team recommends buying today. There is no obligation to subscribe.

This article was first published March 10, 2009. It has been updated.

Fool contributor Rich Smith owns shares of optionsXpress, LoopNet, and Blackboard. Blackboard is a Hidden Gems recommendation, while LoopNet is a former selection. optionsXpress is a Stock Advisor pick. The Motley Fool has a disclosure policy.