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Four Ways to Upgrade in the Bear Market

Financial strength will carry these high-quality firms through the crisis.

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It's frightening when a 5% drop in the major stock indexes seems like just another day, but such is life in late 2008. The volatility in the market is still exceptionally high, and the drumbeat of bad economic news continues. I know it is very tough out there, and I have felt the pain, too. However, we need to keep our heads if we are to come out on the other side of this successfully.

For those who are getting nauseated by this volatility and the seemingly day-by-day draining of the stock market's value, consider this: Bear markets are excellent times to "trade up" in the quality of the companies in your portfolio.

Allow me to offer up four ideas with rock-solid balance sheets, all with wide economic moats, trading well below their fair value estimates and with single-digit forward P/E ratios. I also own all four of these in the StockInvestor portfolios (as well as personally). Even though each of these companies has its own set of challenges, their balance sheets make this group assured survivors of the current credit crisis. And in this severe economic climate, I think focusing on the survivors is incredibly important.

 eBay (EBAY)
Cash & Investments: $3.8 billion
Debt: $0
Net Cash Per Share: $2.91
Stock Price: $12.30
Fair Value Estimate: $40
Price/Forward Earnings (consensus): 7.8
Although eBay faces an uphill battle restarting growth at its core auction business, PayPal continues to post powerful growth, with revenues up 27% last quarter. Companywide sales were up 12% in the third quarter, and eBay is still on track to generate in excess of $2 billion in free cash flow this year, equating to a free cash-flow yield greater than 14%. Not a bad price for a company with such a strong balance sheet.

 ExxonMobil (XOM)
Cash & Investments: $38.4 billion
Debt: $10.3 billion
Net Cash Per Share: $5.43
Stock Price: $68.93
Fair Value Estimate: $91
Price/Forward Earnings (consensus): 9.0
Although lower commodity energy prices will likely make earnings from earlier this year the high watermark for some time to come, Exxon still remains solidly in the black with a single-digit forward P/E ratio. Moreover, it is hedged operationally to falling prices. In a lower-price environment, oil-rich countries will have a greater need for both Exxon's expertise as well as its capital. ExxonMobil's pure size is also a thing of wonder. Beyond the healthy cash balance, this company has $123 billion in property, plant, and equipment on its balance sheet, with essentially no financial leverage.

 General Dynamics (GD)
Cash & Investments: $2.6 billion
Debt: $2.1 billion
Net Cash Per Share: $1.20
Stock Price: $57.55
Fair Value Estimate: $81
Price/Forward Earnings (consensus): 8.8
Although this defense company's balance sheet does not have a huge pile of cash like the others in this group, General Dynamics has something else the others don't have: a huge $60 billion backlog, representing more than two years' worth of sales. Plus, with unique capabilities for building large-scale projects like battleships and nuclear submarines, Uncle Sam has a vested interest in maintaining this company's health.

 Microsoft (MSFT)
Cash & Investments: $20.7 billion
Debt: $2.0 billion
Net Cash Per Share: $2.04
Stock Price: $20.30
Fair Value Estimate: $35
Price/Forward Earnings (consensus): 9.2
It has been four years since Microsoft paid out a special $3.08-per-share dividend to rid itself of more than $30 billion in excess cash it had on the balance sheet. And despite hefty share buybacks that have reduced shares outstanding by 16% during the last three years, the cash continues to pile up at a rate close to $1 billion per month. I expect Microsoft to continue buying back shares and/or increasing its dividend.

Note: Balance sheet data is as of Sept. 28, 2008, for General Dynamics, and Sept. 30 for the others. Stock prices and fair value estimates are as of Nov. 12, 2008.

This article was originally sent as a StockInvestor subscriber alert on Wednesday, Nov. 12. Click to learn more about StockInvestor.

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Paul Larson has a position in the following securities mentioned above: EBAY, GD, MSFT, XOM. Find out about Morningstar’s editorial policies.