Finding Bargains in an Overheated Market

I don't know about you, but to me, this looks like a pretty expensive market.

I mean, I know that people are buying stocks like Apple at current prices. I know that Apple has tons of cash, and that it's unlikely to stumble as long as Steve Jobs remains healthy. And I love the company and its potential. But ... I couldn't do it. Not when Apple's stock has more than doubled in the last few months, and not when it's trading at more than 30 times earnings.

Although the stock market has moved toward retrenching in recent days, there are an awful lot of very fully valued stocks out there. And while there's a compelling argument for buying anyway, or at least holding on -- even if the recent rally turns out to be a new bull market, we're still in the early stages -- my value-obsessed brain struggles with that.

But it turns out that there are still bargains out there.

Looking for value in a very rich market
What's "value"? Generally, when people say they're "value investors," they mean that they're looking for good companies that are out of favor with the market for one reason or another -- sectorwide challenges, recent difficulties that are past but still fresh -- and priced accordingly. Ideally, these stocks are cheap enough have a margin of safety, meaning that their actual share price is lower than their intrinsic value per share.

By buying with as much of a margin of safety as we can find, we -- in theory at least, over time -- limit our downside. The thing is, the intrinsic value calculation is just an educated guess, so it's rarely a sure-fire thing. But if we do our due diligence carefully, we can greatly reduce our downside risk -- or, as one of my favorite pro value investors, Mohnish Pabrai, is fond of saying: "Heads I win, tails I don't lose much."

That's my kind of bet.

Turning up possibilities
So where do we look? I like to screen on a few basic indicators that say "value" to me. Price-to-earnings is an old-school way of taking a quick look at value, and while there are arguably better indicators, it's one I still like to use.

Also, I think a look at the company's debt load is key. It's an indicator of overall health, and it helps screen out some of those companies that are "cheap for a reason." Return on equity is a fast-glance look at management effectiveness and the company's overall health.

You can find those on nearly any stock screener, though I like to use the Fool's (free) CAPS screener because I can also limit my search to four- or five-star stocks. Here are some I turned up recently:

Source: Motley Fool CAPS.

So what have we got? All of those companies have P/E ratios under 13, but that in and of itself doesn't tell us much. All of them have low long-term debt levels. Lockheed Martin's is a bit high, but I left it on the list because of that crazy-high return on equity, and I would need to do more research to understand the story there. And all of them save Lockheed Martin have five-star CAPS ratings, which I've found to be a reliable "look closely at this one!" signal.

Of course, as we all know, even stocks that screen well are sometimes cheap because of problems we're better off avoiding. We call those value traps, and avoiding those is essential -- that's why it's so important to take the time to really understand what you're buying.