Exploiting the Averages

"Opportunity of a lifetime"
When a car salesman uses that line, I run for cover. When a stock picker uses it, I wrinkle my nose. But when stock pickers as diverse as Jim Cramer and Christopher Davis are both saying the same kind of thing, I perk up my ears.

Cramer, who's best known for tossing chairs and hyping the occasional pile of speculative junk, has been urging investors to move money into value, particularly into beaten-down, high-quality companies such as Johnson & Johnson (NYSE:JNJ).

That's interesting because it matches what we're hearing from noted value investors such as Christopher Davis (scion of the legendary Shelby Davis, who turned $50,000 into nearly $900 million over half a century). He recently said we're in a rare moment of market history. Once every decade or so, he told SmartMoney, "you can buy the stalwarts." He's looking at companies such as Wal-Mart (NYSE:WMT) and Microsoft (NASDAQ:MSFT).

Why stalwarts? Why now?
There are plenty of investors out there who think the stalwarts are fine during any season. I'm not among them. I love the great companies, but I only want to get them when they're cheap -- which may happen even less frequently than once every decade. That's because paying fair value, even for the best of companies, is a great way to end up with mediocre returns. Investors like Buffett, Davis, Dremen, and Miller have pointed to their portfolios as evidence that cheaper stocks provide the best returns over time. And many academic studies have proved the same thing.

In fact, the academic work suggests a low P/E portfolio can outrun a high P/E portfolio by more than 10 percentage points annually. With a modest portfolio, over 20 years, that could make a million bucks' worth of difference.

That's a difference of $958,192.

How does it work?
According to the stock pickers as well as the eggheads, the reason cheap stocks outperform is because, sooner or later, everything reverts to the mean. That is, companies -- or the market in general -- tend to keep moving toward an average price. These averages fluctuate too, but studies have shown that reversion does happen, even if it means hitting a moving target. Eventually, too expensive moves toward reasonable, and so does too cheap.

Get mean
But how do you define cheap? It can be as simple as looking at the current P/E and comparing it to the mean, or average, over time.

Yes, the P/E ratio is an old-school tool. And yes, it's got its failings. But as a shorthand for the price the market is willing to pay for a company, it's tough to beat. Just as markets move toward mean P/E ratios, so do stocks. When you can find stellar companies trading at deep discounts to what the market is usually willing to pay for them, it's a good bet that, after time, those prices will move back up toward the average.

Seven opportunities of a lifetime?
Here are a few of the many stalwart stocks I've found currently trading at significant discounts to their five- and 10-year average P/E ratios.

Look before you leap
Unfortunately, a historically cheap P/E is only a starting place for further consideration. Cyclical stocks at the top of a cycle carry ultra-low price tags, but that's because the bottom may be about to fall out. And superstar stocks coming off long periods of overvaluation may look cheap in retrospect, but only become cheaper as the market prices them for a new reality.

In fact, some of the stocks above carry low prices because the market fears the go-go growth is gone for good. If the appetite for Harley hogs, Brunswick boats, or Nike sneakers does go sour, these currently cheap-looking ratios won't save shareholders. Personally, I think there's already too much pessimism baked into many of these shares. I think they'll be heading back toward the mean over the next year or two, which is why they're at the top of my watch list, if not already buttressing my portfolio.

Get help getting mean
As those historical P/E multiples show, the market's best companies aren't always served up with hefty discounts. That's why it's important to pay attention when the opportunity does come along. But Cramer, Davis, Dremen, and the rest of the value crowd aren't the only ones salivating at the prospects these days. Microsoft and Wal-Mart are already recommendations of my colleagues at Motley Fool Inside Value, where sorting out the real bargains from the value traps is a never-ending task. If you'd like a free look at a full stable of stocks that may be giving us once-in-a-lifetime buying opportunities, a 30-day trial is on the house.

At the time of publication, Seth Jayson was long shares of Johnson & Johnson and Microsoft, as well as Microsoft calls. He had no position in any other company mentioned. View his stock holdings and Fool profile here. See what he's Digging these days. Johnson & Johnson is a Motley Fool Income Investor recommendation. Fool rules are here.