Yes, You Can Still Find Bargain Stocks

Think the bull is finally back?

I'm skeptical. We may be up, but I'm not so sure we're going to stay up. Consider:

• Home foreclosures, mortgage delinquencies, and mortgage "modifications" were all up significantly in the second quarter, according to a new report from the Treasury Department.
• A key barometer of business activity in the Midwest failed to show growth in September, coming in well below expectations, suggesting that the much-hoped-for recovery has yet to gain traction.
• Likewise, consumer confidence is still slipping. And if consumers aren't spending, recovery is going to be a challenge.
• The S&P 500 has had a great run since the lows of early March, but it's now trading at around 19 times cyclically adjusted earnings. That's somewhat high; the long-term average is a bit over 16. Given the economic fundamentals, a sharp pullback may be in order -- soon.

On the one hand, we hear a lot about how the worst is behind us. And that might well be so. On the other hand, there's still weakness out there, some stocks are sporting seriously unreasonable valuations, and to my eye things are looking ripe for a correction.

But if you've got money to invest, I think it's still a good time to buy -- if you know where to look.

The bargain bin is still well-stocked
Here's the thing about this rally: A lot of solid companies haven't really been part of it. Of course, that's true of most rallies -- a bedrock principle of value investing is that there are nearly always bargain-priced good companies to be found in out-of-favor sectors. If you can find those, and buy 'em cheap, you'll be well-positioned for gains over the longer haul.

Of course, "bargain" is often a relative term, but what I mean is companies that are selling for a low price relative to their earnings. Good companies, ones that are generating a high return on their capital, have a good chance of sustaining that return, and have low debt loads.

Put another way, we want great stocks with a margin of safety, the term we use when a company's share price is lower than the company's intrinsic value per share.

But what if they're cheap for a reason?
Well, it depends on the reason. If a stock is cheap because its big-idea founder just got indicted for something awful and the business is reeling, that's not a good sign. But if it's cheap because it's in the oil and gas business and people are unsure of the short-term direction of energy prices, that's not necessarily a bad thing. In fact, it might be a good thing for us.

But that's why we emphasize the margin of safety. Of course, intrinsic value calculations are just educated guesses, even more so while the economic outlook remains uncertain. But if we know what to look for, and we put some time into understanding the company and its industry, we can skew the odds of success in our favor.

Some examples to check out
Where do we find them? I always start with screeners, like the excellent (and free) screener that's part of Motley Fool CAPS. Using the CAPS screener and a few others, I recently turned up this list of possibilities:

Sources: Motley Fool CAPS and Yahoo! Finance.

These stocks don't have tons in common, but what they do have in common matters: Reasonable price-to-earnings ratios, low debt, and a high return on equity -- meaning that management is doing a good job managing company financial resources. They're all also a little bit under Wall Street's radar at the moment. That's what we want.

Of course, we'd need to do further research before buying any of these, because sometimes stocks that look like bargains aren't. We call those value traps -- steer clear.