By Dan Ferris, editor, Extreme Value

Thursday, December 11, 2008

In his best-selling book, One Up on Wall Street, Peter Lynch wrote, "The stock market requires great conviction, as surely as it victimizes the unconvinced."

So... how do you prevent yourself from becoming one of the "victimized unconvinced"? How do you get that awesome feeling of certainty buying stocks when the S&P 500 continues to make new lows, as it did about two weeks ago?

The best way to invest with a great sense of conviction is to buy world-dominating franchises when they're selling for prices that are obviously cheap.

The first part of the equation is easy... Look for the No. 1 company in its industry. Most world dominators are well-known brand names, like Coke, Wal-Mart, or UPS.

But the second part – buying at the right price – is vital for making a fortune in stocks over the long term. The one thing that will prevent you from becoming a victim is knowing what a business is worth and paying far less...

Let me show you what I mean with an example... Microsoft (MSFT) is the world dominator in personal computer software.

Last year, Microsoft did more than $18.4 billion in free cash flow. Free cash flow is all the cash generated by a business in excess of all the expenses and reinvestment required to maintain and grow the business. (If you like balance sheets as much as I do, you can calculate free cash flow yourself by going to the cash flow statement and subtracting capital expenditures from operating cash flow.)

Right now, you can buy every share of Microsoft for about $183 billion – about 10 times one year's free cash flow. World dominators like Anheuser-Busch, Wrigley, and Gillette, all went private for 28-30 times free cash flow.

Though Microsoft is too big to go private, it's easily worth at least double what it's selling for today. Ten times free cash flow is absurdly cheap.

When presented with a deal like this, you don't have to sit around and suck your thumb, worrying if you're doing the right thing. You can buy and hold with great conviction.

Let me show you another example... ExxonMobil (XOM) is the biggest and best-run oil company in the world. It pulls oil out of the ground for $8 a barrel – less than just about anybody. It's also the most profitable company of any kind in the world, with over $40 billion of net income last year.

ExxonMobil generated $42 billion in free cash flow over the last four quarters and has more than $38 billion in cash on its balance sheet.

Right now, ExxonMobil is selling for a market cap of about $400 billion – less than 10 times free cash flow. Even better, ExxonMobil tends to spend all of its free cash flow on dividends and share repurchases.

When a stock this great is selling for such a fantastic price, you can buy with conviction. That's all that's left to do with ExxonMobil right now.

When the valuations on stocks like Microsoft, ExxonMobil, and other great businesses get this cheap, you don't waffle about stock market bottoms. You buy them and hold on to them with great confidence.

If you're doing anything else, you're letting the opportunity of a lifetime slip away.

Good investing,

Dan Ferris

Further Reading:

The Secret to Finding Cheap World-Dominating Stocks

Why Your Government Wants You to Smoke Cigarettes

Market Notes

GOLD STOCKS ARE REBOUNDING LIKE CRAZY

Just like our infrastructure trade, the gold stock trade we covered last week is "fast out of the gate."

To recap, gold mining stocks are among the greatest "boom and bust" assets in the market. They attract the market's craziest speculators... guys that believe in Freemason plots and Grassy Knoll gunmen. These shares are also highly dependent on the price of gold... which fluctuates like mad in wild economic times.

The market trashed gold miners this fall. Most fell over 50% in just a few months. It's beaten-down assets like these that tend to rise the most after a big market selloff.

"Rising" doesn't quite describe the action in gold stocks since we wrote up the trade. "Soaring" is more like it. The most popular basket of gold stocks – the Gold Miner ETF – gained 8% yesterday... and is up 18% in just the past week. Considering that gold is soaring (Americans just don't realize it), this is just the beginning of the rally.

Don't Be a Stock Market Victim

Market Notes

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