You can find stocks today that will double in the next three years.
Yes, that's an aggressive prediction (particularly in this market), but recent volatility has made some outstanding stocks available for cheap. They're so cheap, in fact, that they will offer 26% annualized returns over the next few years.
How can you find them? By focusing on three key criteria.
1. Value
There's no point in buying stocks if you aren't getting them at a bargain price. By definition, fairly priced stocks will have only average performance. And if you're just trying for average performance, you may as well just buy an index fund.
If you actually want to beat the market, you have to buy stocks for less than they're worth. Suppose that you buy a stock for 40% less than its fair value. If that stock just returns to its fair value, you'll get a 67% return. Even if it takes two years to bounce back, you still get a 29% compound annual return.
Apple was a good example of this. For months back in 2003, Apple traded just barely above its tangible book value, and a big chunk of that tangible book value was cash. Investors were basically saying, "Apple has only scrap value. Its innovative development teams, $6 billion in sales, excellent brands, and loyal customers are worth absolutely nothing."
But investors who actually looked at the business could see that it was undervalued by at least 50%. Those investors have done spectacularly well. Half of their gains are due to Apple's rock-bottom price at the time.
2. Growth
You can do well with undervalued stocks that don't grow, but growth puts you over the top. It can sometimes take a couple of years for an undervalued stock to reach its fair value, and if the company grows during that time, then the fair value increases, giving you a bigger upside. What's more, if a company is growing, you can delay taking a gain, since the value of your investment will also continue to grow.
The combination of growth and value can lead to excellent gains. Our Inside Value investing service recommended Chesapeake Energy (NYSE: CHK) in the winter of 2006, when it was in the low $30s. Not only did Chesapeake seem significantly undervalued at that price based on recent acquisitions by ConocoPhillips (NYSE: COP) and Devon Energy (NYSE: DVN), but we also expected that it would grow quickly, as it switched its focus from acquiring to drilling land.
We were right. The fair value of the stock increased dramatically, and the share price grew even faster. Chesapeake has increased 58% in a little over a year, thanks to a lucrative combination of the company's growth and the stock increasing to its fair value.
3. Sustainability
You'll want to buy stocks that will grow for years -- an extremely important criterion that investors frequently overlook. For example, SanDisk (Nasdaq: SNDK) has often demonstrated excellent growth and seemed undervalued in the past. But SanDisk operates in the highly competitive flash memory market, where it's very difficult to sustain growth or profit margins. As a result, the stock has endured mediocre returns.
You can make the same argument with Palm (Nasdaq: PALM). Palm's smartphones proved extremely popular with consumers, and they fueled some impressive growth between 2004 and 2006. However, Palm's advantages were short-lived. The company's key rivals, like Research In Motion (Nasdaq: RIMM) and Nokia (NYSE: NOK), have the sustainable competitive advantages -- more cash, better marketing, bigger R&D budgets, and more manufacturing capacity.
It's hard to overestimate the importance of sustainability. Every long-term winner in the stock market is successful because it has a sustainable competitive advantage. Apple, for example, has its brand, its innovation, and its customer loyalty.
The Foolish bottom line
Value, growth, sustainability. When these three characteristics come together, you have the potential for 100% gains within a few years -- so focus on them like a laser beam.
If you'd like some help, we search for all three each month in Inside Value, and we believe that many of our recommendations have the potential to double over the next three years. If you're interested in reading more about those stocks and all the stocks we like for new money now, click here to join Inside Value free for 30 days. There's no obligation to subscribe.
This article was first published Feb. 12, 2008. It has been updated.
Fool contributor Richard Gibbons will do a happy dance if his portfolio doubles in three years. Chesapeake Energy is an Inside Value pick. Apple and Palm are Motley Fool Stock Advisor selections. The Fool's disclosure policy is flirtatious.
