Contrary to popular belief, diversification isn't the best way to manage risk. Buying good companies when stock prices are beaten down or 'discounted' is a great way to maximise your upside whilst minimising your downside.
Buying 'blue chips' or established businesses is great (if they're cheap) but I couldn't name any stocks from the S&P/ASX 20 (ASX: XTL) that are 'bargains' at current prices. Buying expensive stocks leaves downside risks too great and their upside too small to justify an investment unless you intend to hold them for a very long time.
Our job as savvy investors is to pick out the stocks that the market has got wrong. For example, fellow Motley Fool contributor Peter Anderson identified Ausdrill (ASX: ASL) as an example of a stock the market got wrong. If you bought Ausdrill on that day (only 3.5 months ago), you'd now be sitting on gains of around 65% plus a 10% dividend.
I held the stock before then and although I paid a higher price, around $1.22, I still think Ausdrill is good place to have money. Ausdrill is a diversified end-to-end mining services company. With major miners as customers and trading on an earnings ratio of around 4.5, it's cheap.
Airline stocks are notoriously badly run businesses. They have huge costs, are in a competitive industry and one mistake can be disastrous for customers, the company and your portfolio. However Air New Zealand (ASX: AIZ) is one company that has sound management, a very strong customer service and employee reputation and is profitable. It currently trades on earnings of 18 and pays a 6.1% dividend.
Despite the likely upwards trend in consumer and business confidence, Myer (ASX: MYR) is still cheap. It pays a 6.8% dividend, trades on earnings of 11 and increased revenues in FY13 despite very harsh trading conditions. Looking forward, with interest rates so low, confidence will return to the retail market and its earnings will likely grow along with it.
Picking up on market noise is pretty easy, particularly when a stock drops in value for something that happened two years ago. Leighton Holdings' (ASX: LEI) stock recently took a backwards step when "new" bribery allegations rocked its management. They were not new and now the company is clawing its way out of the mess with a cheaper price tag.
Some stocks in mining are cheap for the wrong reasons, others for the right reasons and some are cheap because people just don't know how to value them. Although I am always sceptical about gold stocks, some are looking appealing. Medusa Mining (ASX: MML) is one gold stock I recently added to my portfolio. Trading on earnings around 6, Medusa has a cash cost of US$313 per ounce and produced over 60,000 ounces last year. It decided not to pay a dividend last year, and will instead reinvest the money into operations in the Philippines, lower costs to around US$220 per ounce and double annual output.
Foolish takeaway
Cheap stocks that pay great dividends can be extremely hard to find, particularly before everyone else sees the potential in them. Although these stocks may pay great dividends, they are still not our favourite!
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Motley Fool contributor Owen Raszkiewicz does not have a financial interest in any of the mentioned companies.
