Check Your Wish List Twice

Some investors find valuing a stock to be a chore. To me, those are the good times. After all, you know what you're after. There's an answer to find, of sorts. It may involve some painful, third-grade math, and your button-poking finger might get a boo-boo, but at least you know your task. And in the meantime, you get to play Encyclopedia Brown, reading through all sorts of mysterious clues -- especially in the proxy statement -- to see whether you can find the thing that doesn't, or does, add up.

For me, the hardest part of the stock game is finding good stock ideas to begin with. We've long since learned that tips from Main Street or the locker room are probably worthless. Screening is useful, but when you select companies by specific criteria like free cash flow or their price-to-earnings ratio (P/E), it's still all too easy for great ideas to slip through the net. Since I'm a dedicated dumpster diver, the 52-week-low lists are another of my haunts. But the trouble with sifting through the Street's trash is that, 99.9% of the time, stuff that's on the scrap heap really, really deserves to be there.

It's times like this that we should take a lesson from Investing 101: Keep a wish list. All of the best investors I know operate this way, and some of the legends you've read about did the same thing. Those piles of folders that Peter Lynch kept on companies? That's a very detailed form of a wish list. And why do you think a guy like Warren Buffett reads just about every annual report he can get his hands on, if not to put together his own wish list? As both of these guys have said, the key to outperformance isn't timing or even superior brains. It's familiarity with good companies, and knowing when they're selling cheap.

Stop looking for the fat pitch
It's a bit of tradition here at the Fool to follow Lynch and others and describe stock-picking in baseball terms. You know the old value-investing saw about being patient and waiting for the fat pitch, and then putting all your energy there? Well, I suggest you stop waiting for the fat pitch. Instead, keep your eye on the fat pitchers, the ones most likely to serve up softballs over the center of the plate -- and tell you before they toss them.

That's what the wish list is -- the patsy pitching roster, a list of companies that will almost certainly provide a fat-pitch opportunity, at the right price. It's easy to put the roster together via one of any number of online portfolio tools, including our own.

My wish list portfolio (cleverly titled "wish list") is composed first and foremost of quality companies, firms with strong -- if not bulletproof -- franchises, and a history of strong returns for shareholders.

I have no hard and fast rules, but the companies on my list tend to fit the following profile:

• They're large caps.
• They profit from major consumer franchises, with recognizable brand names, such as Kraft (NYSE:KFT). They sell stuff that people keep buying again and again.
• They're not too cyclical (because of the above-mentioned trait.)
• They pay a dividend. Even if it's not huge, most tend to return some of their cash earnings to shareholders.
• They generate strong returns on invested capital. I prefer to get 'em above 14%. That way, you can be pretty sure -- without doing any math -- that the firm is making a big return relative to its cost of capital.
• They are the kind of companies that are very likely to be doing the same thing two decades from now, profitably.
• They hide in plain sight. That is, the Street follows them pretty well, but despite the coverage, they're still prone to investor pessimism or plain old neglect.

Some of the companies on my list include Procter & Gamble (NYSE:PG), Harley-Davidson (NYSE:HDI), Microsoft (NASDAQ:MSFT), Dell (NASDAQ:DELL), Starbucks, AltriaGroup (NYSE:MO), and Johnson & Johnson (NYSE:JNJ).

Care and feeding of the wish list
Since I sit at a computer all day working on my shoulder hunch, myopia, and carpal tunnel tendonitis, I can check my bobbers several times a day. When one of them sinks a few percent, I start to investigate. Ideally, I'm hoping for one of those short-term revenue waggles that send investors scurrying, like the recent downward guidance at UST that caused the stock price to sink (and moved that company from my wish list into my real, live portfolio.)

If you can't be bothered to keep your eye on the roster yourself, you can easily set up your wish-list tickers via Yahoo! Finance's alerts, which will notify you automatically when one of your fat pitchers takes the mound. For example, I'd be very interested in any of my wish-list companies should they drop 5% in a day, so that's where I set my alerts.

When to buy
A price drop in a strong company is exactly what us value types are looking for. Of course, not all drops are created equal. Some are well deserved, some not so much. So remember, the wish list is foremost just a source of ideas.

Normally, the strict methodology we follow at Inside Value dictates that we think only about buying companies trading at safe discounts to our estimate of their intrinsic value -- say 20% or more. (Whether that intrinsic value is based on discounted cash flow analysis, an evaluation of hard assets, a dividend discount model, or some other method is another question.)

But as I suggested recently in another piece, with some companies (firms that Wall Street chronically overvalues because they deliver such superior results with such consistency), it may not be such a sin to buy them at a smaller discount to what we consider the fair value to be -- say 10%.

Many of my wish list stocks, like J&J or P&G, fall squarely into this column. (That's why they're on the wish list.) I'd be comfortable adding a partial position to my portfolio whenever the firm takes a dive and starts trading at a discount to its historical self -- in other words, at valuation ratios (price-to-earnings, enterprise value-to-EBITDA, enterprise value-to-sales, and so on) below the norms. Barring fancy software, it can be tough to find these historical ratios and screen for discrepancies, although MSN MoneyCentral's advanced stock screener will let you select companies by comparing the current P/E with a five-year average P/E.

What's up with my wish list these days? Here are the rough valuation ratios for some of the fat pitchers on my roster:

Past price and present
A simpler way to check a firm's current P/E relative to the past is using our charting tools. Price action in isolation is a poor way to judge a firm's valuation relative to earnings, but the bottom indicator on this J&J graph shows the progress of the firm's P/E ratio.

As you can see, the market will very often pay more than the current P/E of 22, but there are also frequent discounts, when the Street marks J&J down to a P/E of 20 or less. For the record, let me state that this is far from a perfect method because the E (earnings) portion of the P/E is backward-looking, while the P (price) portion reflects investor sentiment about the future. As such, it will work best with mature companies that have strong franchises and fairly steady growth. And if you consult that J&J graph, you'll see that, in fact, buying when the P/E hit 20 would have been a pretty decent strategy for the past half decade.

The Foolish bottom line
In life, luck favors the prepared, and this is especially true for investors. There are many great companies out there that we'd like to own, but you don't make any money by paying full price. But even the best of companies stumble or fall out of favor as the Street moves money from old and boring to the next big Google. Keeping the best of these stocks at the front of your mind will help ensure that you see the fat pitchers shambling up to the mound, long before they start lobbing softballs over the plate.

For related Foolishness:

• Learn more about our hunt for dirt-cheap dream stocks.
• Why value? Because investing in the next big thing can be bad for your wallet.
• Can you ever get value at fair value?

If you're interested in more fat patsies to watch, and a few very fat pitches that are currently hanging out over the plate, waiting to be walloped, consider joining the fun at Inside Value by clicking here. A 30-day trial will cost you nothing.

Seth Jayson is wondering whether he shouldn't just keep his mouth shut and buy a few shares of P&G and J&J. At the time of publication, he had shares of UST but no positions in any other firm mentioned. View his stock holdings and Fool profile here. Fool rules are here.