There are three areas of the market that I've been scouring for undervalued stocks recently: banks, oil, and small caps. Why these three in particular? Here's my rationale for each (as well as some specific stock ideas).

The banking sector may be the most complex, opaque market segment. Derivatives, accounting quirks, deleveraging, and government intervention make this so. As a result, there is a lot of opportunity out there for those who can parse out the winners. But just because there is opportunity doesn't mean it's a good idea to make individual calls in the sector.

I've written before about the dangers inherent in the sector. Bank of America and Citigroup are popular because they were left for dead at one point. They've recovered somewhat from a price standpoint -- leading to multibaggers off the lows -- but they still share the complexity problem with their stronger peers, including Wells Fargo, Goldman Sachs, Morgan Stanley, and JPMorgan Chase. All of these banks either have significant investment banking operations or have swallowed up a fallen toxic bank.

I see more opportunity in the smaller, simpler banks. I bought into one of my research candidates Community Bank System back in July and continue to wait for better prices on a few others.

I chose oil specifically, rather than the energy sector as a whole, because I feel more confident in buying into an oil major like ConocoPhillips (NYSE: COP ) than I do an alternative energy player like Solarfun (NYSE:SOLF). The gains in alternative energy could indeed be huge, but similar to the slew of Internet companies in the late '90s, it's exceedingly difficult to separate a winner like Google (NASDAQ:GOOG) from the companies that crashed and burned. And even if you do, the price may be too high. Both eBay and Yahoo! are trading way below their bubble highs from almost a decade ago.

Despite the alternative energy threats, our dependency on oil should exist for quite a while. The opportunity for large gains comes in buying oil companies (from the little guys like Dawson Geophysical to the ExxonMobils of the world) on weakness -- specifically when there's oil price weakness.

I first wrote about this back in the spring when oil was closer to $50 a barrel. There may be good opportunities now (particularly as a hedge against rising energy costs), but if oil falls back into the $40s and $50s, and oil stocks weaken, definitely do your research and consider seizing the opportunity.

Small caps
There are certainly bank and oil small caps that are worth researching (I mentioned a bank example already) if you have the requisite expertise. But small caps (i.e., companies with market capitalizations between $200 million and $2 billion) span every sector out there, so if banks and oil aren't your thing, you can tailor your search to your circle of competence.

Small caps tend to be more volatile than their larger brethren, so when the stock market experiences turbulence (read: now!), small caps experience earthquake-like movement.

When the price is right, we can capitalize.

Let me walk you through a screen I'm using to find promising small caps. It's a little boring, but stick with me, because there are some interesting stocks at the end.

I'm not interested in temporary beauty, so I looked for companies that had both positive earnings and positive free cash flow for the last five years. For cheapness' sake, I also made sure the companies were trading for less than 10 times the most recent earnings and free cash flow numbers via the P/E and P/FCF metrics.

A lot of wonks bicker over whether P/E or P/FCF is a better metric. Frankly, I see no reason why both earnings and cash flow shouldn't be strong -- we want companies that are both accounting profitable and generating cash off of that profitability. As a final check, I made sure the companies were easily able to cover their interest payments.

The screen generated 19 companies, but one in particular caught my eye. Here's the complete list: 


P/E Ratio

P/FCF Ratio

Meadowbrook Insurance Group






Chart Industries



Pre-Paid Legal Services






FPIC Insurance Group



Apogee Enterprises



PH Glatfelter



Hawaiian Holdings






Sterling Construction



PDL BioPharma



Advance America



American Physicians Capital



ProAssurance (NYSE:PRA)



Innophos Holdings



SeaBright Insurance (NYSE:SBX)



Employers Holdings



Rent-A-Center (NASDAQ:RCII)



Source: Capital IQ, a division of Standard & Poor's.

Of the select 19, the one that caught my eye was Innophos Holdings, a specialty phosphates producer. First, because of its tiny P/E and P/FCF ratios under 5.0. Second, because it's a recommendation of our small-cap experts over at Motley Fool Hidden Gems.

Their goal is to identify the most unloved, undervalued small-cap stocks in the market, so it's not surprising that a phosphate producer has made their list. They feel strongly enough about Innophos that they have bought shares with The Motley Fool's own money.

I invite you to learn more about the stock and see their entire real-money portfolio by taking a free 30-day trial. There's no obligation to subscribe.

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This article was originally published Aug. 21, 2009. It has been updated.

Anand Chokkavelu owns shares of Community Bank System and long-held shares of Citigroup. Google is a Motley Fool Rule Breakers pick. Innophos and Dawson Geophysical are Hidden Gems recommendations. eBay is a Stock Advisor choice. Motley Fool Options has recommended a bull call spread on eBay. The Fool owns shares of Innophos Holdings and has a disclosure policy.