This Recession Is Gonna Make Me Rich (again)

Investors today face a dilemma. With the Dow still down 30% from its peak, top investors like Chuck Acre, Whitney Tilson, and Warren Buffett keep reminding us that stocks are cheap.

On the other hand, every day, newspapers report another round of layoffs, and bleak headlines leave us all wondering how low stocks can go.

So if you think today's an utterly lousy time to invest, well, I certainly can't blame you.

That said ...
Do you remember the Internet bubble? I sure do. When the Great Bubble burst in 2000, I saw my portfolio fall directly into the commode -- down 40% in the space of a few months.

See, back in 2000, I bought into the worst of the worst tech stocks. The overhyped Palm IPO. The overpriced Cisco. Worse, I ignored the obvious value in Apple (Nasdaq: AAPL) -- trading at a pre-iPod valuation very near its own cash balance. Long story short, I paid the price for my mistakes. But as the market slowly turned around, I eventually recovered my losses -- and then some.

Of course, the financial crisis we're facing today is far more widespread and threatening than the Internet bubble was. Nevertheless, over the course of time, I learned that building real wealth consists of three simple, timeless steps:

• Earn as much as you possibly can.
• Save as much as you possibly can from what you earn.
• Invest those savings.

Working as many as five jobs simultaneously, my wife and I scrimped and saved. We cut corners. And no matter how much we took home from work, we strove (not always successfully, I admit) to put away at least a third of our income for a rainy day. Then we invested it.

Invested in what?
I set out to describe the investment philosophy I learned from Motley Fool co-founder Tom Gardner. The result was a 2004 column I entitled "7 Steps to Finding Gems." You can read it for yourself just by clicking through the link, but here's the dime tour:

I invested in companies that:

• Had superb management
• Generated significant free cash flow
• Grew that cash flow quickly, and
• Traded for cheap prices

How cheap? To keep it simple, I sought out companies selling for a price-to-free cash flow-to-growth (P/FCF/G) ratio of less than 1.0. It's really a fancy-pants version of the PEG ratio, popularized by legendary former Magellan Fund manager Peter Lynch. I prefer free cash flow over GAAP earnings as a measure of profitability; while GAAP profits may be good enough for the SEC, I believe free cash flow is a more reliable indication of financial health.

Now here's the best part
It was easy finding great companies that fit this criterion after the Internet bubble burst. But ever since 2005, I've been having trouble finding many stocks selling for as cheap as I'd like to pay -- until now.

Thanks to the Great Sell-off of '08, stocks finally offer investors today the chance to earn the kind of profits I reaped back in 2001-2005. Yes, even now that the market has "returned from the dead," bargains still abound. Running one of my favorite stock screeners in search of bargains last week, several likely suspects popped right up, each trading below my target valuation:

Data from Finviz.com and Yahoo! Finance.
*Based on consensus five-year earnings-growth estimates.

Word to the Foolish
Now, I cannot emphasize enough how you should use the names and numbers above as a starting point only, for your own research. Dig around in the newsfiles for these companies, and you're bound to find a surprise or two that may warn you away from investing in them right away.

For example, Shanda Games -- that 7.4 price-to-free cash flow ratio looks pretty attractive, doesn't it? But SG is a recent spin-off from mothership Shanda Interactive (Nasdaq: SNDA). As such, its financial statements are essentially an exercise in woulda-shoulda-coulda hypotheses; a guess at how the company might have performed if it had been independent prior to spinning off. In short, tread carefully on this one. It's also unclear how tougher industry regulations will affect the company.

Time the market? No. Mark your calendar? Yes.
And another thing -- before you buy, keep a close eye on the calendar. For example, the stock topping the above list, American Science & Engineering, is getting ready to release earnings for its fiscal second quarter. Before buying, ask yourself: How confident are you that the company will perform as expected? (Chances are, if the first time you heard of it was on this stock screen, you're probably not confident enough.) Personally, I expect AS&E to excel, but I've owned it a long time myself, and I follow its performance closely.

If you don't, and you haven't, let me humbly suggest that while next week's earnings report is a great time to learn more about the company, this week is a lousy time to go gambling on an unknown.

And speaking of "learning more" about these companies, it's our job at Motley Fool Hidden Gems to make that job easier for you. Every stock we recommend, we track. Closely. And every stock we recommend, we update you on. In detail. Every month.

So if you want to get a handle on some of these stocks, but could use a helping hand, come join the service that has walloped the S&P's returns for nearly six straight years. Take Motley Fool Hidden Gems for a free trial on our dime for 30 days. No strings attached.

This article was first published March 10, 2009. It has been updated.

American Science & Engineering, iRobot, and Shanda Interactive Entertainment are Motley Fool Rule Breakers recommendations. Apple and MSC Industrial Direct are Motley Fool Stock Advisor selections. Jinpan International is a Hidden Gems pick.

Fool contributor Rich Smith owns shares of AS&E. The Motley Fool has a disclosure policy.

This article was originally published as This Recession Is Gonna Make Me Rich (Again)on Fool.com

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

Copyright 2009 Motley Fool. All rights reserved.