Dirt Cheap Dream Stocks

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

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 endured the hysteria in 1993 were rewarded with outsized profits; an investment made during the lean years would have yielded 820% returns. That's right. This classic turnaround, once considered at death's door, gave investors a nine-bagger.

Wouldn't you love to find (and, more importantly, invest in) the next IBM? Especially now, when many excellent companies have seen their share prices plummet by 30% or more in a matter of weeks?

Yeah, we all would, and I think we're smart to aim high. That's what we search for here at our Motley Fool Inside Value investment service. And history shows us that dream stocks -- like IBM -- occasionally become available on the market. For 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 invested capital (ROIC); 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 at least 10 or 20 years. Those dream stocks are like perennial plants, coming back year after year and multiplying along the way, without fertilizer or sprinkler systems.

And, believe it or not, dirt cheap dream stocks are available right under your nose. By snooping around the market, it's possible to find underappreciated stocks that Wall Street has unfairly penalized. Analysts are bearish. The public is selling.

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

Take, for instance, Johnson & Johnson. The venerable American brand bottomed out near $30 (split-adjusted) in March 2000, in part because its heartburn medicine, Propulsid, which had $940 million in 1999 sales, was yanked from the market.

Also consider Altria, which in the spring of 2003 was reeling from lawsuits, increased taxes, and discount competitors in its Philip Morris USA unit. Bankruptcy talk was in the air. Fears of large-scale litigation drove the stock price down to bargain prices -- but those fears were overblown.

IBM, J&J, and Altria have all regained focus and have come roaring back. Investors spotting these stocks would've been handsomely rewarded for sticking with such solid companies when others were selling.

Prices are split- and dividend-adjusted and include spinoffs, if any. Data from Yahoo! Finance.

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, and experiencing deflated share prices as a result. 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. History has proven that, over time, the value approach gives investors the potential to hit home runs. In an article last year, I cited an Ibbotson Associates study showing that value investing outperformed both growth investing and the S&P 500 from December 1968 to December 2002. During that time, value stocks returned 11% per year; the S&P returned 10.2%; and growth stocks, 8.8%.

Mimic the masters
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 strong business with high ROIC and long-term competitive advantages.

Follow in their paths, and the approach is simple: Search for unloved companies. Read the newspapers to search for castaways. Listen to ideas from others (I frequent our wonderful Foolish community of message boards). Scour 52-week-low lists, which today seem like a who's-who of blue-chip names: Adobe Systems (NASDAQ:ADBE) and American Express (NYSE:AXP) are two intriguing companies that recently hit a yearly low.

Run the numbers via stock screens. For instance, below I've provided you with four companies that have been beaten down in the past year but that have some attractive features:

*Last 12 months. Data from Capital IQ, a division of Standard & Poor's.

I'm not recommending these companies per se -- they'll require further research and due diligence on your part -- but their operational efficiency, mixed with their current multiples, warrants a closer look.

When searching for juicy value bargains, I calculate a stock's fair value based on my discounted cash flow analysis. Then it's just a matter of sitting back and waiting patiently.

I wait for the actual stock price to slip below the fair value estimate, giving me a margin of safety. When I spot such a bargain, I jump in ... and I patiently wait again, 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
Don't be turned off by terms like solid and patient. Although value investing isn't a get-rich-quick scheme, we're giddy to use descriptors like tremendous or out of this world to characterize our returns.

Sometimes, the down-and-out companies stay down -- and then bow out. Follow the value luminaries and learn the difference.

Or, you can be my guest at Inside Value for 30 days and get the ideas flowing. You'll receive two stock recommendations per month, as well as full access to every buy report to date. And the first 30 days are on me. There's no obligation. Let's go hunting for the next dirt cheap dream stock together.

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

Philip Durell is the co-advisor of Motley Fool Inside Value. He owns shares of Dell, but of no other companies mentioned in this article. Microsoft, American Express, and Dell are Motley Fool Inside Value recommendations. Johnson & Johnson is an Income Investor choice. Precision Castparts is a Stock Advisor pick. The Motley Fool owns shares of American Express and has a disclosure policy.