How to invest in GOOD but CHEAP stocks

Many investors have a love affair with cheap stocks, but as Mr O'Neil (http://www.dpbolvw.net/click-2855045-10496841) puts it: "Stocks are cheap for a reason". In many (but not ALL) cases, investors try to grab stocks on the cheap without realizing that they're buying stocks of a company mired in problems with slowing earnings, sales growth and shrinking market share. These are bad traits for a stock to have, cheap or otherwise.

Nonetheless, although most cheap stocks are priced at their value, many savvy value investors (read: Warren Buffett) have still successfully made fortunes buying cheap BUT GOOD stocks. So how did they do it? Below are some quidelines for smart value-investing (i.e. buying good stocks cheaply)

1. Buy a business, not a stock.
   
   When evaluating a stock, see yourself as a business owner, not a stock investor. Only buy businesses that you understand. Warren Buffett is well known for ignoring the 1999 surge in dot.com stocks, refusing to buy stocks in technological companies because he couldn't understand the business. Only when you understand the business, can you effectively evaluate important questions like: Is the company's stock cheap because it is losing market share? Is the new product offered by a rival company going to negatively impart your business?
   
   
2. Buy stocks in companies that have a proven track record.
   
   This includes a consistently good EPS, sales, equity and free cash flow growth rate. Generally, we want to see the above growth rates consistently above 10% for the last 10 years. In addition, we want to see a long history of great ROIC (above 10% for the last 10 years). We should also insist that ROIC is either going up, or at least staying the same.
   
   
3. Buy stocks that have a big MOAT
   
   A moat is a 'protective shield' that a company has that prevents other companies from invading their territory. Examples of moats include
   
   - Brand name: The company has a very strong brand name that makes it difficult for other companies to claim their market share. An excellent example is "Apple", with its group of die-hard fans.
   
   - Secret: The company has a patent or trade secret that makes competition illegal or very difficult. Example: 3M.
   
   
4. Buy stocks with a good and honest management
   
   Traits of honest management include admitting their mistakes (if they did not produce results for a quarter, they should admit it and explain how they intend to rectify it) and accepting a reasonable compensation for their work. A CEO that takes home $40 million a year when the stock price dropped by 50% is not our type.
   

At this point, you may be wondering: If a company has such an excellent record and characteristics, why is the stock cheap?

Most of the time, these companies stocks are cheap because of a temporary problem (such as missing EPS estimate for one quarter) or because the overall market is bearish. At times like this, you can normally buy the stocks cheaply, preferable at a 50% discount.

In my next post, I'm going to show you how to use Investor's Business Daily to look for cheap stocks with good fundamentals. Stay tuned.