INVESTING COMMENTARY

• 3 Bargain Stocks for This Market
• 7 Stocks That Are Swimming in Cash
• Not Listening to Buffett Cost Me Thousands
• The Highest Possible Returns. Period.

3 Bargain Stocks for This Market

By Ilan Moscovitz
November 22, 2009

In " 70 Times Better Than the Next Microsoft," my colleague Bill Barker revealed which category of stocks outperformed from 1927 to 2005. Given the insane market volatility we've experienced recently, I've updated Bill's numbers through the end of 2008, to see what critical lessons we can draw. Here, then, are the returns for four categories of stocks from 1927-2008:

Category

Value

Growth

Large Cap

10.9%

8.9%

Small Cap

13.6%

9.0%

Source: Kenneth French. Categories are based on market capitalizations and price-to-book multiples.

This data comes from highly respected scholars Fama and French, and it has powerful implications for investors.

It shows that over an 81-year period -- hardly a small sample size -- value stocks outperform growth stocks, and small stocks outperform large stocks. The best-performing category was small-cap value stocks, by a widemargin.

How wide?
They may look like small percentage differences, but with compounding, those small percentages add up to mind-boggling amounts of money. Here's how much $100 invested in 1927 in each of these categories, and rebalanced annually, would be worth today:

Category

Value

Growth

Large Cap

$437,860

$97,682

Small Cap

$3,086,003

$103,798

In other words, after 81 years, investing in small-cap value stocks would have yielded anywhere from seven to 31 timesas much money as any of the other categories!

A big reason for small-cap value's dramatic outperformance is Wall Street's constant obsession with large, prominent companies -- like today's McDonald's (NYSE: MCD) and Yum! Brands (NYSE: YUM). Both are fantastic operators, but when hunting for bargains, investors should keep in mind that more prominent stocks such as these are far less likely to be mispriced than somewhat obscure small caps like Buffalo Wild Wings (Nasdaq: BWLD).

It's no accident, after all, that every one of the market's 10 best-performing stocksof the past decade was a small cap.

And when you combine a group of stocks that tends to be mispriced (small caps) with a group of stocks trading at low valuations (value), you're likely to find some great bargains.

Here's why
When a closely watched company appears cheap, there's often a good reason for it. That's why, in a column last September, I warned investors to stay awayfrom Citigroup (NYSE: C), Lehman Brothers, and Wachovia.

Even though they were trading at or well below book value, these were closely followed institutions, dealing with continuing writedowns, managerial missteps, and deteriorating businesses. With so much interest in their condition from Wall Street hotshots -- each had more than 16 analysts following it -- it seemed likely that their share price declines were justified.

That may not be the case for small caps. In fact, research cited in The Wall Street Journal, along with my own findings, shows that small caps tend to outperform when the market rebounds. In fact, the top performers since the market's March lows were largely small caps.

Why? Because small value stocks are less closely followed by professionals, they are more likely to be mispriced. So when times are tough -- and times have been tough since late 2007 -- that mispricing means that small caps are punished beyond justification.

What to look for today
This isn't to say that small stocks are low-risk. Indeed, if this market has taught us anything, it's that everystock has risk. But the data does indicate that size itself isn't a great measure of safety.

From the start of this recession until the March market bottom, the small-cap tracking Russell 2000 index was basically in line with the S&P 500, and it has rebounded more rapidly.

And when we examine fallen giants such as Citigroup, Bank of America (NYSE: BAC), JPMorgan Chase 's (NYSE: JPM) prey WaMu, and the assets formerly known as Lehman Brothers, we see that risk has less to do with whether a company is large or small, and a whole lot more to do with heavy debt levels, shoddy executive compensation structures, unwieldy and arcane business units, or unprofitability.

In light of these facts, investors should consider buying companies with:

In fact, these are all qualities that Warren Buffett says he seeks. So, taking the lessons from the Fama and French data, and with a debt of gratitude to Buffett, I've selected three small-cap value stocks (each has below-market-average price-to-book value multiples -- Fama and French's value metric) that share those qualities:

Company

Market Capitalization

Price-to-Book Ratio

Debt/Equity

Insider Ownership

Return on Equity

Cal-Maine Foods

$660 million

1.95

39%

40%

21%

PriceSmart

$578 million

1.93

15%

35%

15%

Shengdatech (Nasdaq: SDTH)

$314 million

1.88

48%

48%

25%

Data from Capital IQ, a division of Standard & Poor's.

Of course, these three bargain stocks aren't official recommendations, but they share many qualities that make for great investments, and they're excellent starting points for further research. Moreover, they hail from the small-cap value quadrant, the category that has outperformed them all.

Some more ideas
More than eight decades of historical data confirms that small-cap value stocks tend to outperform over the long haul. Research also shows that if you're going to be looking for great small-cap stocks, now is a particularly great time to begin bargain-hunting.

Our Motley Fool Hidden Gems team looks exclusively at small caps with limited analyst coverage, little or no debt, and dedicated leadership. With stocks so cheap, they're seeing some incredible bargains today. If you're looking for more ideas, click hereto read all about our favorite small-cap stocks, free for the next 30 days.

Already a member ofHidden Gems ? Log in here .

This article was first published May 5, 2009. It has been updated.

Ilan Moscovitz owns shares of Buffalo Wild Wings and Shengdatech, but he does not own any small kittens. Buffalo Wild Wings is aMotley Fool Hidden Gems recommendation. The Fool's disclosure policy is crazy for Pounce!

This article was originally published as 3 Bargain Stocks for This Marketon Fool.com

Copyright © 2009 The Motley Fool, LLC. All rights reserved.

7 Stocks That Are Swimming in Cash

By Nick Kapur
November 22, 2009

Some say cash is king.

And nowadays, many ( The Economist , for example) are saying it loudly.

According to The Wall Street Journal, 64,000 companies bit the dust and filed for bankruptcy in 2008. And, terrifyingly still, credit markets have continued to brace for significant increases in corporate default rates thus far in 2009.

For those companies that survived that first wave of financial shocks, the reallybad news is that over the horizon loom the aftershocks. Debt will still require repayment, employees will still want their paychecks, and electricity bills will still fall on their doorstep every month. Companies needcash, and the ones holding a lot of greenbacks should do quite well. At least, that’s the theory.

I've found seven companies that have tons of cash, but it doesn't really matter. Let me explain why.

Cash helps, no doubt
I think we can all agree that an adequate amount of cash on the balance sheet is an excellent defense for a company facing complete financial destruction. Without cash on hand, not even the most iconic of companies, such as General Electric (NYSE: GE) or FedEx (NYSE: FDX), could survive. Bear Stearns went under not because of insolvency, but because it had no liquidity.

But there's a bigger problem.

You may be looking at the cash line on a company's balance sheet with the belief that companies with lots of cash will be the companies that can avoid bankruptcy, and therefore be properly positioned to succeed in the future. You might be tempted to buy shares of these companies.

Not so fast.

I agree -- to some extent. These companies probably won't go bankrupt (in the near term, at least), but it has nothing to do with how well the company can or will do in the future. That train of thought will steer investors into a classic mistake.

Show me the money!
I've selected seven companies with market caps larger than $500 million and cash in excess of 12.5% of that market cap (which is a lot of cash!) to illustrate a simple point:

Company

Market Capitalization
(Billions)

Cash and Cash Equivalents
(Billions)

Apple

$186.4

$23.5

Las Vegas Sands (NYSE: LVS)

$11.6

$3.1

Alcatel-Lucent (NYSE: ALU)

$8.7

$6.1

Amgen (Nasdaq: AMGN)

$56.8

$14.0

Pfizer (NYSE: PFE)

$147.3

$52.4

Activision Blizzard (Nasdaq: ATVI)

$14.8

$2.7

Sprint Nextel

$10.6

$5.9

Source: Capital IQ, a division of Standard & Poor's.

These are relatively some of the cash-richest companies in the world. But that fact alone doesn't have any bearing on whether they make for good investments.

Market beaters? Maybe.
These companies could be burning through cash faster than a teenager with your gold card -- or they could be tossing lots of money into that expensive new pet project that may or may not work.

You just don't know with these figures alone. The financial picture remains incomplete.

A tale of two opposites
Take Apple and Sprint Nextel, for example. Both have lots of cash. But Apple has more than $23 billion in cash and equivalents, has no debt, has hauled in billions in free cash flow in the past 12 months, and pushes returns on invested capital at rates in the ballpark of 20%.  

Sprint, on the other hand, has $5.9 billion in cash, carries a whopping $22 billion in debt, fails to deliver nearly as much cash flow per revenue dollar, and fails to push positive return rates on invested capital. Most of the cash that is made just goes back to debt holders.

Suffice it to say that these are two different companies in two remarkably different places.

I'm not saying that Apple is a much better investment than Sprint; I'm simply trying to illustrate why looking at cash figures can be completely misleading.

The same is true when comparing a company like Activision with Alcatel-Lucent. Both have lots of cash, but gee-whiz Alcatel has some serious work to do if it wants to re-inspire shareholders.

Cash is just one piece of the puzzle
Instead of simply highlighting companies with huge bank vaults, ask yourself whether a given company will be adding to that stockpile in the future or taking away from it. And most important, identify just what the company intends to do with that cash.

Companies sporting generous coffers can't guarantee that their products are going to sell in the future or that their industries are sustainable for the long term.

Cash is necessary -- necessary to avoid bankruptcy in the short term and to operate properly in the medium term. In fact, we Fools like our stocks to support healthy cash cushions in the (likely) event of an emergency. But cash can only get you so far. Companies still need to have a plan -- a good plan -- for that cash.

The truth is stranger than fiction
There is another wrinkle you should know about cash and the people who hold it. According to research confirmed by several different sources, the best managers of cash tend to be, ironically, the same companies that regularly redistribute it back to shareholders in the form of dividends.

As the master of your own money, you can probably appreciate how a dividend-paying company with limited resources must be more disciplined with its spending, because it knows it'll have to pony up a dividend to shareholders on a regular basis. Over the long run, these institutions generally become better stewards of capital.

The difference isn't marginal, either. Research has shown that from 1972 to 2006, S&P 500 dividend-paying stocks actually performed significantly better than their non-paying peers -- by a sizable margin of six percentage points per year! That outperformance can be at least partly explained by the burden (a blessing for shareholders) of having to pay a dividend regularly.

Foolish bottom line
Cash is a good thing. Most companies can sidestep total collapse with lots of the green stuff. But having cash today won't help you navigate the difficult waters of business tomorrow. And it doesn't mean that you, as a shareholder, will ever see a dime of it.

That is why the Motley Fool's Income Investor service looks not only for companies with strong balance sheets -- so they can avoid bankruptcy in the present -- but also demands that their companies develop the long-term fiscal discipline that is promoted by paying a regular dividend. The strategy works: 83% of our recommendations are beating the market for an overall S&P outperformance of 7.0%.

Want to take a free look? Click herefor a 30-day trial to the market-beating service.

This story originally ran Feb. 1, 2009. It has been updated.

Nick Kapur owns shares of Activision. Activision, Apple and FedEx areMotley Fool Stock Advisor recommendations. Sprint Nextel and Pfizer areInside Value selections. The Motley Fool has a disclosure policy .

This article was originally published as 7 Stocks That Are Swimming in Cashon Fool.com

Copyright © 2009 The Motley Fool, LLC. All rights reserved.

Not Listening to Buffett Cost Me Thousands

By Bruce Jackson
November 22, 2009

Earlier this year, Forbes ranked Berkshire Hathaway (NYSE: BRK-B) Chairman Warren Buffett as the second-richest man in the world, with an estimated net worth of $37 billion. While his net worth had dropped by a cool $25 billion over the preceding 12 months, it's still an impressive haul.

Although some people have recently questioned his judgment, Buffett is still almost universally accepted as one of the world's greatest stock market investors. When he talks, it pays to listen.

The Oracle is commonly considered a value investor, but he seems just as focused on growth. Either way, he has proved that he's an intelligent investor. As Buffett's sidekick Charlie Munger once said, "All intelligent investing is value investing."

Google as a value stock
Buffett focuses on companies with favorable long-term economics and strong competitive advantages -- companies such as Coca-Cola , ExxonMobil (NYSE: XOM), Wal-Mart (NYSE: WMT) and recent acquisition Burlington Northern Santa Fe (NYSE: BNI), all current Berkshire investments.

One Wall Street analyst called Coca-Cola "very expensive" around the time Buffett started buying it. It wasn't a typical value stock. But as Buffett once said: "If you gave me $100 billion and said, 'Take away the soft-drink leadership of Coca-Cola in the world,' I'd give it back to you and say it can't be done."

Now that'sa competitive advantage.

See, value investing is notall about buying stocks with low price-to-earnings, price-to-book, or price-to-sales ratios. Far from it.

For example, Google would have been a great value stock at its IPO in August 2004, despite selling, at the time, for more than 100 times earnings.

A value stock trading for more than 100 times earnings? Yep. Google was growing rapidly, continuing to take market share, and building sustainable competitive advantages in its enterprising culture, superior advertising platform, and brand loyalty. Given its growth rate ever since and its powerful business model, it was underpriced back then.

Investing shock: Buffett was wrong
Buffett didn't buy Google. Sadly, neither did I -- a decision that has cost me thousands.

I held off on buying Google shares because they seemed expensive. I knew it owned the vast majority of the search-market share and had both a great corporate culture and innovative leaders. But I couldn't get past that lofty P/E ratio.

Instead, I was concentrating on buying poor companies on the cheap. These "trash stocks," as I call them, have a nasty habit of getting even cheaper -- and sometimes even going bust.

At least I'm not alone in buying trash stocks. In his 1989 letter to Berkshire Hathaway shareholders, Buffett himself admitted to similar crimes. In a section of the letter called "Mistakes of the First Twenty-Five Years (A Condensed Version)," Buffett says he never should have bought control of the textile company Berkshire Hathaway.

Why? Even though he knew that the textile-manufacturing business Berkshire operated was part of a declining industry, he was enticed to buy because the price looked cheap. The Berkshire of today wouldn't exist without that original purchase, but Buffett reluctantly closed the textile business in 1985.

And that brings to mind a timeless Buffett-ism: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

Value investing for suckers
I'm a great fan of Warren Buffett and like to think of myself as a value investor. But too often I've been guilty of buying those "trash stocks" -- cheap stocks with mediocre (or worse)  businesses.

Although I've never owned them, over the years, I've come close to buying shares in Boeing (NYSE: BA), Wynn Resorts (NYSE: WYNN) and even AIG (NYSE: AIG) -- all of which appeared relatively cheap but operate in intensely competitive industries and/or carry plenty of debt.

Twenty years have passed since that famous 1989 letter to Berkshire Hathaway investors. As I review my portfolio today, I see fewer and fewer "trash stocks."

Through a combination of expensive errors, experience, and a commitment to continued investing education, I've slowly come to realize that the best long-term investments are in companies in growing industries that possess long-term, sustainable competitive advantages.

A heady combination of value and growth investing
If you need stock ideas today, there are more than a few such companies among our recommendations at Motley Fool Stock Advisor. I've known Fool co-founders and Stock Advisoradvisors David and Tom Gardner for more than a decade now, and both are intelligent, business-focused investors.

Since the newsletter's inception in April 2002, their recommendations have outperformed the market by 49 percentage points on average. If you'd like to learn more about their latest stock picks and five favorite ideas for new money, give it a try  free for the next 30 days.

I wish you happy, trash-free investing.

This article was first published March 7, 2008. It has been updated.

Bruce Jackson finds taking out the trash satisfying. He is a beneficial owner of Berkshire Hathaway shares. Berkshire Hathaway is aMotley Fool Stock Advisor recommendation. Google is aRule Breakers selection. Berkshire Hathaway, Wal-Mart and Coca-Cola areInside Value recommendations. Coke is also anIncome Investor pick. The Fool owns shares of Berkshire Hathaway, and its disclosure policyis enlightening.

This article was originally published as Not Listening to Buffett Cost Me Thousandson Fool.com

Copyright © 2009 The Motley Fool, LLC. All rights reserved.

The Highest Possible Returns. Period.

By David Gardner
November 22, 2009

In 1992, I was 26 and already spending my fair share of time online. For several years, I'd been a satisfied customer of America Online. Although I liked the service, I decided not to buy shares of the company at the initial public offering that year. I thought I'd wait a while. (Idiot.)

I kicked myself for two years while the stock quadrupled. In the spring of '94, I followed my instincts and became an AOL shareholder -- in spite of an article in a major financial publication that declared AOL grossly overvalued and predicted that the stock would decline by 35%.

The following year, the stock dropped 25% or more three times. And then in 1996, shares absorbed a drop of 65%! Despite these setbacks, the company went on to wreak havoc on both the business and journalistic establishments, en route to putting up some of the best returns available during a decade of great investment returns.

Even with all the temporary downturns, and even though the stock is today down from its all-time high, my initial investment has still increased about 27 times overall -- which amounts to an annualized return of more than 25%.

We'd all love to find the next AOL or Johnson & Johnson (NYSE: JNJ) or Wal-Mart . That goes without saying.

But how can ordinary investors like you and me -- a couple of regular Fools -- find the next great company? It's not impossible. If you can train your eyes to spot innovative companies breaking the rules in their industries, you increase your odds dramatically.

You can't score if you don't shoot
The Wise of Wall Street would chalk up AOL's 25% annualized gains to luck. "No one can really identify the great companies of the next generation," they'd say. Growth stocks are too risky; it's best to avoid that style of investing altogether and let a Street "expert" manage your investments.

I disagree. Investing in great companies early in their high-growth stages and then holding them for the long term will provide the highest possible returns. Period.

We call those companies Rule Breakers. Our investment service of the same name seeks out the great growth stocks of tomorrow -- the potential AOLs -- before the Street catches on.

Think big, but keep an eye on the basics
Boiled down, I look for six signs of a potential Rule Breaker:

Sign No. 1: Top dog and first mover in an important, emerging industry
Top dogs are active, fast-moving market leaders. In 1994, AOL was a top dog. Some years earlier, Microsoft was a top dog before making its impressive run. First movers seize a temporary edge over the competition, then exploit that advantage. These companies come from emerging industries -- like biotechnology today or e-commerce a few years back -- because it's unlikely that the railroad or meat-packing industries have much room left to run.

Rule Breakers are not hidden; they are right before our eyes, and they bring a disruptive technology, clever and effective marketing, or a brand-new business model to this little backwater planet of ours. They rattle our capitalistic foundations.

Sign No. 2: Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors
Can the company protect the advantage it obtained from its first-mover status? Netflix , for example, is absolutely dominating online video rental and is consolidating its power over the entire rental industry.

Sign No. 3: Strong past price appreciation
Sometimes, the best investments appear overvalued. I bought AOL after it quadrupled. Was Tiger Woods unknown before he joined the professional tour and started winning majors? Was No. 23 unheralded when he joined the Chicago Bulls after his junior year at North Carolina?

Sign No. 4: Good management and smart backing
This is the most important attribute of all … and it might be the most difficult to get right. Few would disagree that visionary leaders are behind the greatest companies of our generation: Microsoft had Bill Gates, Starbucks (Nasdaq: SBUX) has Howard Schultz, Whole Foods (Nasdaq: WFMI) has John Mackey, and Urban Outfitters (Nasdaq: URBN) has Richard Hayne. Investors should also be prepared to learn about the venture-backers of a young company. If the very best venture capital firms are behind a company, maybe you should be, too.

Sign No. 5: Strong consumer appeal
Rule Breaking companies provide products or services that improve the quality of people's lives. Microsoft, for example, made home computer use a reality.

Sign No. 6: You must find documented proof that it is overvalued according to the financial media
This is the easiest one of all to identify. Every day, the Wall Street pooh-bahs declare that this or that stock is overvalued. Google shares begin trading publicly, and the naysayers predict another tech "meltdown." Even today, with the vast majority of stocks having taken huge hits, there are some companies with improving fundamentals that Wall Street is afraid to touch because they appear more expensive than others.

If a company's growing earnings lead to an increasing valuation, someone somewhere will surely argue that the company is overvalued. The reason this is valuable is that it keeps people out of a stock; later on, as the company proves out its position as a profitable, even dominant, leader, then the skeptics finally buy -- which is what can give you serious appreciation as an early investor in Rule Breaker stocks!

Before they were blue chips
So there you have it. Those are the characteristics I look for in tomorrow's landscape-changing companies.

It's essential to our strategy to identify great companies early in their growth cycles. Then we hold for the long term. Indeed, many of the best examples of Rule Breakers are today's blue-chip companies. You may recognize a few:

Company

Date*

Initial Investment

Current Value**

Return

Compound Annual
Growth Rate

Gilead Sciences (Nasdaq: GILD)

1994

$1,000

$57,432

5,643%

29%

Nucor (NYSE: NUE)

1985

$1,000

$29,654

2,865%

15%

Qualcomm (Nasdaq: QCOM)

1993

$1,000

$29,664

2,866%

24%

*Two years after the company went public.
**All prices adjusted for splits and dividends.

Each of these companies had the six signs of a Rule Breaker at one point in its growth cycle -- and each posted fantastic returns as a result. There are other not-as-famous companies out there -- hundreds of them -- that once were poised for the limelight but now are forgotten. In most cases, the flameouts and the fakers significantly lacked one or more of the signs we pointed to above.

There is no trade-off
With detailed information on more than 6,000 publicly traded companies, the stock market can't help being fairly efficient. But the market doesn't have all the information, does it? Many people insist on following the rules laid down by Wall Street or by the latest "this is the way to invest" fad investment book, regardless of how banal or unsuccessful these prescribed rules behave in practice.

There's our opportunity. My team of analysts at our Motley Fool Rule Breakers investment service searches obsessively for these opportunities. Each month, we give you two new Rule Breaking ideas that we believe are worth holding onto over the long run and will have superior returns to the market.

If you'd like to read our analysis of all our potential Rule Breakers in greater depth, join us for a free 30-day trial today. You can cancel your trial at anytime -- you have my word. Click here to learn more.

And one last thing. As big-time Rule Breaker Steve Jobs told Stanford graduates: "Stay hungry. Stay Foolish."

Already a member of Rule Breakers? Log in at the top of this page .

This article was originally published June 23, 2005. It has been updated.

Fool co-founder David Gardner owns shares of Whole Foods, Netflix, Microsoft, Starbucks, and AOL's parent company, Time Warner. Johnson & Johnson is anIncome Investor recommendation. Whole Foods, Starbucks, and Netflix areStock Advisor selections. Microsoft and Wal-Mart areInside Value picks. Google is aRule Breakers choice.Motley Fool Options recommended diagonal calls on Microsoft. The Fool has a disclosure policyand owns shares of Starbucks. 

This article was originally published as The Highest Possible Returns. Period.on Fool.com

Copyright © 2009 The Motley Fool, LLC. All rights reserved.

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