Dirt Cheap Dream Stocks

Let me take you back to 1993. IBM posted an $8 billion loss and its share price was in free fall. Technology was changing the world, and IBM was not adapting. It was losing hardware business to Dell and Hewlett-Packard and software sales to Microsoft and Oracle. Wall Street was panicking.

But this was a solid company with a long history. It was just three years removed from its most profitable year ever, and although times were tough, new CEO Louis Gerstner had a vision to turn the ship around. Indeed, Gerstner and his new management team came on board and taught that old elephant to dance.

In one of the greatest turnarounds in history, IBM has bounced back -- and then some. Investors who saw through the hysteria in 1993 were rewarded with outsized profits: An investment made during the lean years has yielded a nearly 1,000% return. That's right, this classic turnaround, once thought to be on death's door, gave investors an 11-bagger.

So, wouldn't you love to find (and, more importantly, invest in) the next IBM?

Yeah, we all would; I think we're smart to aim high. That's what we do here at our Motley Fool Inside Value investment service. And I'm here to tell you that dream stocks -- like IBM -- occasionally become available in the market. For cheap. Dirt cheap.

Dare to dream ... of big returns
I'm talking about the kind of stock that will help you sleep at night: one that's underpriced and comes with a long-term, sustainable advantage over its competitors; a high return on equity (ROE); a sterling balance sheet; loads of cash; consistent dividend payments; a high credit rating; and a history of share buybacks. When I happen upon that kind of company, I want to make it part of my core holdings for 10 to 20 years. You may not believe this, but it's unlikely that I'll ever sell it. Why would I? Those dream stocks are like perennial plants, coming back year after year and multiplying along the way, without fertilizer or sprinkler systems. In those situations, I'm more inclined to look for further opportunities in the future, maybe two or three years down the road, to add to the position.

How do you find them? No, you don't need to scour the obscure universe of nanotechnology or try to pinpoint the next "can't-fail" dot-com. It's not nearly as complicated as Wall Street wants you to believe. Dirt cheap dream stocks are available right underneath your nose.

By snooping around the market, it's possible to find underappreciated stocks that have been unfairly penalized by Wall Street. Analysts are dumping them. The public is selling. When everyone else runs, my interest is piqued.

To spot a turnaround, I look in specific places: wounded elephants, former glamour stocks, or fallen angels, to name a few. I demand several things from a candidate, including a solid management team, free cash flow, competitive advantages, and attractive tangible assets.

Take, for instance, Nike (NYSE:NKE). In early March 2000, Michael Jordan was playing golf in retirement. Sales were slumping. International child labor law problems loomed. Competition from Timberland (NYSE:TBL) cut into its market share. The stock plummeted to $25.12, more than half of what it was the previous year. But Nike had been going strong for decades, and its competitive advantages were strong.

Or how about Cadbury Schweppes (NYSE:CSG)? Shares of the British food and drinks company bottomed out in $18.63 in early 2003. Management launched a restructuring program for the company's North American businesses and called 2003 "a year of transition." Slumping sales were blamed on increased competition from the likes of PepsiCo (NYSE:PEP) in the U.S. soft drink market.

Also consider Altria, which, in the spring of 2003, was reeling from lawsuits, increased taxes, and discount competitors pummeling its Philip Morris USA unit. Bankruptcy talk was in the air. While fears of large-scale litigation drove the stock price down to the mid-$20s, I valued it closer to $52.

Nike, Cadbury Schweppes­­­­­, and Altria have all regained focus and have come roaring back. Investors spotting these stocks would've been handsomely rewarded to stick with such solid companies when others were selling.

The purpose of this table is not to cherry-pick or play rearview mirror tricks. It illustrates the point at which several truly great companies were facing their greatest struggles, leading to deflated share prices. These companies have come a long way -- and their returns reflect that. Ask yourself: Would you have had the guts to buy at the bottom?

Value investors probably would, and history has proven that, over time, the value approach gives investors the potential to hit home runs. In an article last fall, I cited a study conducted by well-regarded research firm Ibbotson Associates indicating that value investing outperformed both growth investing and the S&P 500 from December 1968 to December 2002. During that time period, value stocks returned 11% per year; growth stocks, 8.8%; and the S&P 500, 6.5%.

Over a much shorter time frame (the past 11 months), our recommendations in Inside Value have continued the trend: Our picks are up 13.3%, vs. 5.5% for the S&P 500.

Mimic the masters
That's right, the first step toward those great returns is to follow the trails blazed by legendary investors such as Benjamin Graham and Warren Buffett. In their value approaches, they've searched for unloved companies with solid management, free cash flow, and attractive assets. While Graham was more conservative, Buffett has gone a step further: He'll pay fair value for a great business with high ROE and long-term competitive advantages.

Following in their paths, my approach is simple. To spot the great turnarounds, I constantly search for unloved companies. I read the newspapers to search for castaways. I listen to ideas at our wonderful Foolish community of message boards. I run numerous stock screens. And then, for the select companies that make it on my Watch List, I run a series of metrics -- including discounted cash flow (DCF) analysis, which I've conducted thousands of times -- to give me my estimate of a company's intrinsic value.

Once I have the fair value, I sit back ... and wait patiently. I wait for the actual stock price to slip below my fair value estimate, giving me a margin of safety for my investment. When I spot such a bargain, I jump in ... and I again patiently wait, this time for the market to recognize the undervaluation, thereby driving up the price of the stock to levels at or above my intrinsic value estimate.

In short, I seek good deals at great prices. Having a margin of safety allows me to minimize the risk while aiming for solid returns.

Putting it all together
Please don't be turned off by terms like "solid" and "patient." Though value investing isn't a get-rich-quick scheme, we are giddy to use adjectives like "tremendous" or "out of this world" in describing our returns.

Sometimes the down-and-out companies stay down. And then bow out. So how can you differentiate an Enron from an Omnicare, a November InsideValue recommendation? The stock is up almost 59% since I picked it, vs. a 10.5% gain for the S&P 500. Or how about Merck (NYSE:MRK) and GlaxoSmithKline (NYSE:GSK), which are on my Watch List? Shares of the pharmaceutical giants have struggled in the past year, but these companies are poised for long-term outperformance.

Why not follow these plotlines along with us? You can take a free one-month trial to Inside Value by clicking here. You'll receive two stock recommendations per month, as well as full access to all our picks to date. And the first 30 days are on me. There's no obligation thereafter. Let's go hunting for the nextdirt cheap dream stock together.

This article was originally published on April 13, 2005. It has been updated.

Philip Durell is the editor of Motley Fool Inside Value. Philip does not have a financial position in any company mentioned in this article. Dell is a Motley Fool Stock Advisor recommendation. Merck is a Motley Fool Income Investor recommendation. The Motley Fool is investors writing for investors.