(This story was originally published on Wednesday, 11th May, 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).

By Rudi Filapek-Vandyck, Editor FNArena

The share market works in essence under very simple and easy to understand basic rules. If you're hot, everyone wants a piece and thus your shares will end up expensively priced. If you're out of favour, nobody wants to be even near you and the shares will become cheap and underpriced.

At some point the risk-reward balance for investors turns in favour of the cheap stocks, even if the risks remain high. Finding that balance is more art than science, and personal risk appetite and market experience often make all the difference. I have argued in the past that "valuation" ultimately trumps everything else, but every astute investor knows cheap valuations can translate into a "valuation trap", as again witnessed by the profit warning from OneSteel ((OST)) this week.

Just to put the OneSteel story in the correct perspective: OneSteel shares are among the cheapest in the share market, and they have certainly remained in this position after another sell-down post the disappointing downgrade by company management. The company is facing so many headwinds, and none are under management's control, that profits will remain under pressure and this will keep the buyers away, for now. Cheaply priced doesn't mean the shares are a no-brainer buy. But come the day that OneSteel's fortunes turn for the better, those who own the shares will reap rich rewards.

How rich exactly? Well, part of the beauty of the "future" is that it cannot be 100% determined in the present or in the past. There are a few benchmarks that can be used by investors to form an idea about what kind of potential investment returns we could be talking about. Certainly, I personally always pay attention to them, so I "know" what exactly we are talking about in terms of future potential.

In the case of OneSteel, post another wave of profit downgrades by analysts, the consensus price target for the stocks has now settled at $2.77, or more than 38% above where the share price closed on Wednesday. Note also consensus dividend forecasts are for a yield of circa 6.1% for FY11 and of 7.9% for FY12.

Another way of looking at the potential upside is through the price earnings ratio, which on downgraded consensus forecasts, has now fallen to 9.9x in FY11 and to 6.4x in FY12. If we assume no further downgrades, which admittedly cannot be guaranteed in the current environment, and 6.4 simply returns to 9.9 over the next twelve months, then the share price should bounce back to $3.10, signalling potential upside of 55%, not including dividends.

The problem with these calculations is there is no guarantee whatsoever that OneSteel shares will actually close their present valuation gap in the short to medium term. Frankly, I think the odds remain in favour they probably will not. But at some stage the tide will turn and that will put the bargain hunters on alert and the share price quickly in demand. What these calculations do show is that it pays to pay attention to undervalued stocks, for the simple reason that "reverting to the mean" or a "normalisation" process of any kind automatically translates into significant investment returns.

This is why bargain hunting, when done properly and with the necessary patience, can bring significant rewards.

Investors should note, however, there are always dangers and risks involved. In the case of OneSteel, the shares looked already like an absolute bargain in early March when they touched $3. As said above, they closed at $2 on Wednesday. Not even the above average dividend yield is going to make up for the difference. Not in the short term. For those with a longer term view, the rationale for owning OneSteel shares hasn't fundamentally changed. They are still cheap, still offer significant long term potential and will at some point reward the patient investor. At some point.

Another stock that is currently cheaply priced is Southern Cross Media ((SXL)) and analysts at Citi put out a report this week wherein they argued investors are shunning the stock for all the wrong reasons. Yes, radio and TV are, strictly taken, "old media", but then nobody is predicting the company is aiming for similar growth as enjoyed by Seek ((SEK)) or Carsales.com ((CRZ)). Underpriced assets do not need a doubling in profits or something similar, just a return to low double digits should do the trick. If the views of stockbrokers covering the stock is anything to hold on to, Southern Cross Media is going to do just that in the years to come and operational synergies from purchased Austereo are going to underpin this growth.

Given this prospect, Price-Earnings ratios of 9.4 (present year) and 8.3 (next year) are arguably too low. Implied dividend yields of 7.9% and 8.4% respectively signal investors are preferring to wait for more concrete evidence. This may also be related to recent profit warnings from Fairfax ((FXJ)) and APN News & Media ((APN)), while STW Communications ((SGN)) also had to concede the advertisement industry is heading for another soft patch.

Similar to OneSteel above, a consensus price target at $2.18 suggests significant upside potential (48%) and with the domestic economy under pressure from the RBA, a reluctant consumer and a strong Aussie dollar, this potential may not come to fruition in the year ahead. But in three years' time the dividend payout will likely run above 9%. A quick calculation takes the total dividend payout by then to circa 26% (three years combined) and easy going, low double digit growth in combination with a small rise in PE ratio (to 11) should take care of the current gap of 48%.

In fact, I quickly calculated that if the PE ratio remains at its current level of 9.5 the shares should generate 25% in share price appreciation on top of the 26% dividend yield. If double digit growth in earnings per share in the years ahead translates into a higher PE of 11, shareholders will see an extra 23% as a bonus.

The way I look at it, I'd rather not be too greedy and be content with the strong dividend payouts while expecting company management will achieve those synergies, while retaining a solid position in key markets. Whatever happens to the PE ratio can then be the unexpected, positive surprise.

Another company that has attracted the attention from value investors is PEP and packaging company Amcor ((AMC)) which shares the same characteristic with Southern Cross Media in that future growth should be underpinned by synergies from the acquisition and integration of Alcan Packaging operations. The difference with Southern Cross Media is, however, the Amcor share price has now crept up to a PE ratio of 16 and that means future growth can disappoint as a contraction in PE multiples significantly reduces the future performance of the share price.

Amcor can serve as an example as to why highly experienced value investors such as Charlie Munger and Warren Buffett in principle never consider investing in a company that trades on a PE ratio above 15. Amcor's growth is anticipated to accelerate to 28% in FY12, which would justify the current PE. Even on such a relatively high multiple, the prospective dividend yield remains highly attractive with consensus predicting 5% this year and 6% next. I have added 10% growth in FY13 and have come to the conclusion that if Amcor's PE only drops to 15 by then, the shares should still achieve 33% in appreciation plus 17% in dividends.

A return of 50% over three years (not guaranteed, mind you) still remains something to look forward to. Were the PE ratio to stay at 16 there would be an extra 12% in share price appreciation. However, those who've paid attention will have noticed the potential returns from both OneSteel and Southern Cross Media can be much larger. Both stocks also still come with higher risks. That's what implied dividend yields well above 4.5-5% (market averages for FY11 and FY12) tell us.

The end conclusion from all these calculations thus becomes: valuation does trump growth, but that is of little "value" when management is about to issue a shock profit warning. Other than that, all stocks mentioned offer above market dividend yields and can serve as examples as to why smart, astute and experienced long term value investors are currently focused on industrial stocks, while leaving silver, rare earths and uranium to the day-traders and the newspapers.

All calculations are based on consensus data available to subscribers on the FNArena website. Where I had to fill in for the third year I assumed an extra year of around 10% growth. All calculations are just that. They serve an educational purpose. None of this should be taken as financial or investment advice. Investors should always consult with a licensed professional before making decisions that affect their future returns or retirement.

P.S. I - All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website.

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FNArena Editor Rudi Filapek-Vandyck will be presenting at:

- ASX Investment Hour

Date = 17th May (12-1pm) Place of action = Wesley Theatre, Wesley Conference Centre, 220 Pitt St, Sydney

Theme = Stocks That Consistently Beat the Market

Wrap = How to beat the market? It's not a super-formula. It's not a sophisticated software program. It's called "investing"; the old fashioned way. Three rules is all investors need to beat the market, to beat their peers, to beat their own expectations. "Investing" is simply a case of knowing what to look for and what to do. FNArena editor Rudi Filapek-Vandyck knows the rules, and he's willing to share. Be ready to be surprised.

- 2011 AIA National Investors Conference

Date = 1st September (The Conference runs from 1-3 September) Place of action = Sofitel Sydney Wentworth Hotel, 61-101 Phillip Street, Sydney

Theme = Market beating dividend stocks

There's an early bird discount rate for this event, see http://www.investors.asn.au/events/national-conference/ - Detailed conference program information can be viewed here http://www.investors.asn.au/events/national-conference/program/#program - Information regarding the speakers can be viewed here http://www.investors.asn.au/events/national-conference/speakers/

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