Today's Bargains Are Right Under Your Nose

• BySham Gad, RealMoney Contributor
• On 2:30 pm EDT, Thursday October 29, 2009

If there is one thing that can be said rather confidently about the 2009 market rally, it's that Mr. Market hasn't been equally generous across all equity categories. In fact, the rally has been more favorable toward smaller, inferior stocks.

What follows next is my argument that today's best investment opportunities exist within the larger blue-chip-type businesses. These names trade at significant discounts to the overall S&P 500 index and at an even greater discount to smaller comparable businesses that are in much weaker financial positions.

Grandpa's Stocks Are Back

I make my argument because I define investing as making bets that offer me the greatest reward with the least amount of risk. My belief flies in the face of the often-perceived notion that assuming greater risk is the only path to potentially higher returns. To me, risk is simply the probability of suffering a permanent loss of capital, not stock price volatility.

So, for instance, over a year ago, I determined that the Latin American steel producer Ternium Steel was one of the most profitable steel companies in the world, as defined by operating margin and free cash flow generation. At time, shares were moving around $30, and I thought that was an attractive price over the long run. A year later, the shares were near $4; today they are near $24.

So despite the volatile ride, shares are down only 15% or so, vastly outperforming the market over the same period. As is often the case in investing, the best time to buy was when the price was declining, because the upside was huge, against little long-term risk.

Thinking about risk in this way, today's most well-known and respected companies represent some of today's best bargains with respect to the next five years or so -- they offer some of the most attractive future returns relative to the downside risk assumed. And as a value investor, downside protection is priority No. 1.

So yes, there may be some smaller-name issues that stand to do significantly better over the next several years, but you need to consider them in the context of the risk assumed. Doing that, most of today's best bets tend to appear in the larger-cap names.

Additionally all the troubles widely known in the economy -- unemployment, no consumer and so on -- favor the quality names that simply have the wherewithal to operate in a future environment characterized by Pimco's Mohamed El-Erian as the "new normal" and by GMO's Jeremy Grantham as "seven lean years."

Finally, these businesses are trading at very attractive prices and are in industries that are first in line to benefit from any positive economic rebound. Look at Pfizer, which trades at a P/E of 14 and pays you nearly 4% in the form of a dividend. Whatever final version of the health care bill passes, you can bank on the fact that we will have more people with insurance.

That's excellent news for Pfizer, which has now become the eighth-largest generic drug company in the world. It's no surprise that Bruce Berkowitz's Fairholme Funds counts Pfizer as its largest position. And the company is a cash gusher: Over $10 billion in free cash per year since 2006 against today's enterprise value of $100 billion.

Exxon Mobil is one of Grantham's more popular holdings trading at 11 times earnings and yielding 2.2%. As you will see today, even at $70 oil -- which was about the average price in the third quarter -- Exxon still makes a ton of money. Sure, the comps with last year will look terrible, but the company is still hugely profitable. It's making money that it uses to buy back stock, pay a dividend and grow the business in emerging markets.

The list of quality, undervalued names goes on and on. You got Kraft Foods trading at 13 times earning and yielding 4.3%, Wal-Mart, which is down almost 10% year to date while other smaller discretionary retailers are up over 100%. Yet I continue to see Wal-Mart's profits going up while most other retailers struggle. And going forward, Wal-Mart faces a future with an incredibly favorable outlook.

It's no coincidence that these names pay dividends, as they factor tremendously into the favorable future returns. And the yields are higher today because of the depressed prices.

Consider this article as part of an overall strategy going forward. If a company like Pfizer can see its stock price go up 7% to 9% a year, the dividend suddenly turns that into 11% to 13%. I would argue that five years from now, an annual return in that neighborhood will be in the top tier of comparable returns.

Your portfolio does not need to be 100% in blue-chip-type quality, although given the favorable outlook, you would probably do reasonably well. Real Money contributor Tim Melvin commented yesterday on how Barry Diller continues to put serious money in Coca-Cola. And if you look at other serious investors like Grantham and Berkowitz, they are very bullish on quality.

Buzz up!