From Joshua Kennon,
Your Guide to Investing for Beginners.
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In the past, we’ve talked about the importance of buying undervalued stocks and how bear markets can actually be a good thing for your portfolio. How exactly can you go about searching for these attractive securities? As with most treasure hunts, you are more likely to be successful if you first know where to look. These helpful hints will give you an idea of which stones to turn over first.

Share Price Stagnation

Sometimes, over a span of many years, a business will continue to grow, generating ever-increasing amounts of cash, repurchasing stock, paying increased dividends, reducing debt, opening new stores, expanding production facilities, moving into new markets, etc., while at the same time it’s stock price remains stagnate (or even falls). When this happens, the average and professional investor alike tend to overlook the company because they become familiar with the trading range.

Take, for example, Wal-Mart. Over the past five years, the retailing behemoth has grown sales by over 80%, profits by over 100%, and yet the stock price has fallen as much as 30% during that timeframe. Clearly, the valuation picture has changed. An investor that read the annual report back in 2000 or 2001 might have passed on the security, deeming it too expensive based on a metric such as the price to earnings ratio. Today, however, the equation is completely different – despite the stock price, Wal-Mart is, in essence, trading at half its former price because each share is backed by a larger dividend, twice the earnings power, more stores, and a bigger infrastructure. Home Depot is in much the same boat, largely because some Wall Street analysts question how fast two of the world’s largest companies can continue to grow before their sheer size slows them down to the rate of the general economy.

Coca-Cola is another excellent example of this phenomenon. Ten years ago, in 1996, the stock traded between a range of $36.10 and $54.30 per share. At the time, it had reported earnings per share of $1.40 and paid a cash dividend of $0.50 per share. Corporate per share book value was $2.48. Last year, the stock traded within a range of $40.30 and $45.30 per share; squarely in the middle of the same area it had been nearly a decade prior! Yet, despite the stagnate stock price, the 2006 estimates Value Line Investment Survey estimates for earnings per share stand around $2.16 (a rise of 54%), the cash dividend has more than doubled to $1.20, book value is expected to have grown to $7.40 per share (a gain of nearly 300%), and the total number of shares outstanding has actually decreased from 2.481 billion to an estimated 2.355 billion due to the company’s share repurchase program.

A Corporate Transformation or Turnaround

Sometimes a fundamental business model or operations of a company can change so substantially that the business is really an entirely different entity. Occasionally, when this happens, the markets are late to the party and alert investors have an opportunity to buy shares before the crowd catches onto the new game. For years following its decline from the royal standard of the department store world, Sears was a really a credit card company in disguise. After its purchase by Buffett Partners in the 1960’s, Berkshire Hathaway slowly became less and less of a textile company until it eventually grew into one of the largest and most profitable conglomerates in the world with nary a textile operation to be found.

Another good example, Wells Fargo has transformed itself from a bank into a financial services company. Following the acquisition of Strong Financial, the corporation is now one of the top twenty mutual fund companies in the United States. In addition to the traditional banking products offered by your corner S&L of yesteryear, WFC also boasts a robust product offering that includes venture capital financing, cash management, payroll services, merchant processing, mezzanine financing, international trade facilities, foreign exchange services, insurance brokerage, and real estate brokerage. As a result, earnings aren’t as inextricably tied to the yield curve as is the case at more traditional banks, providing the shareholders a better chance at growth through fee and service revenue regardless of the general economic outlook.