Buffett's Stealth Values

The best way to find value in the market is to look where others either won't or don't. When no one's buying something, it can be purchased on the cheap. When others finally start to pay attention to what it's worth, they'll be happy to pay up.

This is, of course, the secret that took Warren Buffett from a numbers-obsessed kid to one of the world's richest humanoids. The amazing thing is that he did it without inventing the computer or the cell phone. He did it by simply purchasing businesses that were on sale and waiting for their value to be realized.

He's perhaps most famous for his purchase of deep value. That's the won't part described above. He saw opportunity in companies that the Street completely shunned -- companies others would not buy because of problems Buffett considered short-term and fixable. His purchases of Coca-Cola (NYSE:KO) and GEICO are perhaps the most memorable of these.

Buffett's stealth secret
But what non-Buffett fans sometimes overlook -- probably because of his frequent complaints that he can't find anything cheap enough to buy these days -- is his habit of purchasing what other people don't buy: reasonably priced businesses with strong franchises and relatively stable earnings. I'm talking about companies like Dairy Queen, Sees Candy, and Benjamin Moore. Enterprises like these can often be on sale not because there's anything wrong with them, but because the Street has forgotten them, even though their signs and products may be on every Main Street or store shelf in America.

I call this kind of company a "stealth value." They're neither dirt-cheap nor expensive. And that's exactly what makes them attractive. The Street is a beast with a short attention span, and it's easily distracted. Companies that aren't flying high or crashing low, well, may as well not even exist. They're invisible.

Sound crazy? I don't think so. In The Purloined Letter, Poe knew that the best place to hide something is right where you'd expect it to be. Anyone who has spent 10 minutes looking for sunglasses that were, in fact, already perched on his head knows this to be true.

Screening for stealth
One of the ways I look for stealth values is to use screens that filter out the very thing that beguiles most other investors: high growth. The rest of my stealth screen is pretty simple:

• Growth in earnings per share between 10% and 25% over the past five years. I wanted to get rid of companies whose high growth would be more likely to attract crazy money. But I'm also looking for companies with a track record of steady growth.
  
  
• Trading at a price-to-earnings (P/E) ratio between 8 and 20. Companies trading at this ratio, at the growth rates above, fit into a broad definition of "reasonable."
  
  
• Trading at a 10% discount to its average P/E ratio over the past half-decade. No reason to pay full price if the market is willing to hand us a deal, right?
  
  
• Market capitalization of less than $10 billion. I'm more interested in slightly smaller companies. Behemoths can grow, too, but it's tougher for them to find room to run.

From this point on, things are a lot more subjective. As I've mentioned, I think a strong consumer franchise is a big asset for these kinds of values -- a familiar brand can mean steady demand, steady demand makes for a more predictable top and bottom line, and those are two things that are essential for extrapolating a company's future value. After weeding out a lot of chaff, I find a lot of interesting companies on the list.

Not surprisingly, I found several stocks that have already caught the eye of our value newsletter, Motley Fool Inside Value. Tax-time stalwart H&R Block (NYSE:HRB), for instance, is on this month's watch list -- not an official recommendation, but something worth keeping an eye on. Interestingly enough, the screen also snagged one of the companies that did get the official nod from our guru, Philip Durell. (Click here if you're interested in a free trial, which will give you a risk-free look at the valuation and write-up.)

The rest of the current field follows:

Of course, a screen like this is just the beginning of the value hunt. Next week, I'll take a closer look at the companies on this list to figure out whether they're stealth bargains or value traps. Lexmark, for instance, recently experienced a huge drop on word that future revenues weren't looking so rosy, and given that it competes in a cutthroat market that demands constant innovation, it may be smart to forget about altogether.

Until then, remember to keep your own antennae up. While the Wall Street's Wise continue to concentrate on this weeks' hot item, there are always ideas for investors with more patience -- and longer attention spans.

If you'd like a look at the more than 25 stocks that our Inside Value team has already run through the wringer and believes are overlooked values, clickherefor a free 30-day trial.

For related Foolishness:

• 2 Things I Learned From Benjamin Graham
• Beat the Street With Value
• Wolverine: Mighty Mustelid

Unfortunately for his wardrobe, Seth Jayson is always looking for a bargain. At the time of publication, he had no positions in any company mentioned. View his stock holdings and Fool profile here. Coke is a Motley Fool Inside Value recommendation. Fool rules are here.