This Recession Is Gonna Make Me Rich (Again)

Investors today face a dilemma. With the Dow still down 29% 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 Sun Micro. Worse, I ignored the obvious value in Toyota -- hoping against hope, I sat on my cash and waited for "a better price." Meanwhile, the highways got crowded with Corollas... Long story short, 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 entitled "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, and
• 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 5-year earnings growth estimates.

One word to the Foolish
Now I cannot emphasize enough how you should use the names and numbers as a starting point only, for your research. Dig around in the newsfiles for these companies, and you're bound to find a surprise or two.

For example, investors often surprise themselves when seeking out growth opportunities in the Middle Kingdom. But Chinese stocks pose notorious risks to researchers. For one thing, they often sit on their cashflow statements till fiscal year end, with the result that the "free cash flow" reported on financial data sites like Yahoo and finviz can become woefully out of date. (In contrast, the SEC requires U.S.-based companies to "show us the money" each and every quarter.)

And another
For another, even the data the Chinese shops do release can be subject to misinterpretation, as U.S. data crunching computers choke on currency conversions, or forget to convert per-share data to per-ADR. Take the apparent-cheapest stock on the list above -- China Unicom. That valuation of "2.7 times free cash flow" looks mighty tasty, don't you think? Well, think again.

Dig into the company's financials, and what you'll discover is that the same data that, according to finviz, makes ChiU look like such a great bargain... is... not... true! A more recent, and accurate calculation shows that ChiU has generated a mere $1.3 billion in free cash flow over the last 12 months, resulting in a true price-to-free cash flow ratio of not "0.16," but... 24.9! Investors trusting in ChiU's double-digit growth rate to make them into millionaires at the former valuation could be in for quite a surprise when they discover the true price tag on these shares.

Fortunately, Fools participating in the Motley Fool Hidden Gems community aren't likely to make this mistake. Between our dedicated team of Foolish analysts on the one hand, and thousands of fellow investors on the other, all double-, triple-, and quadruple-checking our assumptions, mistakes like the one that led finviz to describe ChiU as a bargain basement stock aren't likely to fool us (note the lack of capitalization.)

So if you want to get a handle on some of these stocks, but could use a hand to help you steer around the pitfalls, come join the service that has walloped the S&P's returns for nearly six straight years. Take Hidden Gems for a free trial on our dime for 30 days. No strings attached.

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. Find out what he does own here, and see his active CAPS recommendations here. The Motley Fool has a disclosure policy.