Home Run Derby Stocks

For baseball fans, particularly those who enjoy a display of power, it doesn't get much better than the Home Run Derby. The annual event brings together eight of the game's most prodigious hitters, who proceed to punish a bucket of baseballs served up by their favorite batting-practice pitchers.

Watching Ryan Howard of the Phillies slam pitch after pitch out of the park during Monday night's contest in Pittsburgh reminded me of two things. First, that even in my peak playing days, I only had warning-track power, which is one reason my baseball career fizzled out shortly after high school.

More important, the contest called to mind the following words of wisdom from legendary value investor Warren Buffett:

I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors (NYSE:GM) at 47! U.S.Steel (NYSE:X) at 39! and nobody calls a strike on you. There's no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.

This pearl of Buffett wisdom is from 1974 -- at a time when General Motors and U.S. Steel were running a bit smoother than they are today.

Keep your eye on the ball
Those who have played the market long enough have learned that it doesn't surrender home runs easily. Like a crafty veteran pitcher, Mr. Market keeps those who step into the investors' batter's box off-balance by pricing stocks efficiently, or disguising undervalued ones so that they aren't easily recognized.

It's really embarrassing to swing at a fastball company with plenty of velocity behind it, only to miss by a mile when the bottom falls out and the firm's trajectory suddenly begins to sink. Fortunately, the market does occasionally make mistakes -- leaving belt-high pitches right out over the heart of the plate.

In my mind, this situation occurs when temporarily troubled (but otherwise solid) companies get pummeled by shortsighted investors who sell first and ask questions later.

I'm not talking about bottom-fishing for weak stocks that have sunk to their 52-week lows, then hoping for a bounce. Instead, I'm zeroing in on fundamentally sound companies that have been unfairly beaten up.

Here's the wind-up
The best place to begin is by screening for stocks that have recently been hammered -- ruling out, of course, deteriorating firms that deserved their punishment. Of those that pass this initial test, I then take a closer look at valuation. After all, just because a stock has retreated, that doesn't necessarily mean it's now cheap -- it could have been dramatically overpriced before the fall.

For this task, I assign the shares a fair value estimate based on the discounted value of the firm's future cash flows. As opposed to ratio-based valuation techniques -- which are limited in scope and sometimes provide conflicting (even misleading) advice -- DCF analysis yields a more definitive answer to whether you're paying pennies on the dollar or vice versa. (To learn more about DCF valuation, click here.)

This fair value calculation incorporates, at least indirectly, capital structure, profit margins, capital expenditures, cash flow growth, and other key aspects of the business. Try gleaning that from a P/E ratio.

Hey, batter, batter, swing!
After running through this simple approach, I found four companies that the market is currently lobbing across the plate. All are well-known market leaders with sustainable competitive advantages, solid returns on equity (ROE), and double-digit earnings growth forecasts. Yet thanks to recent pullbacks, each is currently trading at a 20% or greater discount to its fair value estimate.

Based on the analysis outlined above, these finalists appear to be some of the market's latest "mistake pitches." These four industry leaders have all produced market-thumping returns over the long haul, but many investors -- myself included -- have been afraid to pull the trigger because of excessive valuation. However, after tumbling sharply in recent months, shares of these stalwarts are once again within reach.

DCF valuation has been successful in the past, and it will continue to be an important tool for value investors.

The home-run trot
It's possible that Mr. Market could be throwing us a curveball with these four companies, and they could sink even lower just as eager investors are ready to swing out of their shoes. However, proven leaders usually bounce back, and it's not every day that these quality companies can be scooped up at today's discounted prices. Opportunistic investors might want to get their batting gloves ready -- just in case.

Of course, investing (much like hitting) is a matter of taste, and we all have different approaches. If none of these stocks is in your wheelhouse, I would recommend stepping into the on-deck circle at Motley Fool Inside Value. Philip Durell -- who has already recommended Dell from the above list, believing its future to be bright -- is always hunting for the market's bargains, and every month he recommends two of the market's best values. Get in the game by clicking here for a free 30-day trial.

And when you hit your next home run, please don't showboat as you circle the bases.

Fool contributor Nathan Slaughter once hit back-to-back homers in batting practice ... at a short field, with the wind blowing out. He owns none of the companies mentioned. eBay and Dell are Stock Advisor picks. The Motley Fool has a disclosure policy.