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Markets

Skip the Big Risks

Plenty of stocks combine solid potential for appreciation with protection against further trouble.

In Roughing It, Mark Twain's book about his travels in the American West, he described feeling "as if an electric battery had been applied to me" when he thought he'd struck a huge lode of silver in Nevada in 1862. Although the claim was denied within days, Twain often referred to this euphoric episode in later writings.

Neuroscientists say that the high Twain felt at the prospect of sudden wealth has a biological origin. As Jason Zweig explains in his book Your Money and Your Brain, the expectation of a windfall causes the release of dopamine, a neurotransmitter that "fires up" the emotional circuitry located in the lower frontal region of the brain. Anticipating such basic pleasures as food, drink and sex triggers a similar response.

Poor odds

For investors, a side effect of this natural response is that the stimulated part of the brain that anticipates a reward -- in this case, a rapidly rising stock price -- is much more sensitive to the size of the potential gain than to the probability of it actually occurring.

Because of the market's harrowing fall over the past year, you might imagine now is an opportune time to "swing for the fences" by buying speculative stocks. But we strongly caution against succumbing to such a natural inclination. Given the perilous state of the economy, this is not the time to take unnecessary risks.

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Fortunately, plenty of stocks combine solid potential for appreciation with strong protection against further trouble. One example is Winn-Dixie (symbol WINN), which operates 521 supermarkets in Florida and other southern states. Because of poor management, run-down stores and fierce competition, the company filed for bankruptcy in early 2005. Having shed all of its debt and about half of its stores, Winn-Dixie emerged from Chapter 11 in late 2006 under the leadership of Peter Lynch, a veteran grocery-industry executive.

Winn-Dixie is now refurbishing its remaining stores, with good results so far: In the quarter that ended last September, gross profit margins rose, sales at newly remodeled supermarkets increased 12%, and overall same-store sales (sales at stores open at least 12 months) went up 3%.

But the stock remains remarkably cheap. At $15 in mid January, Winn-Dixie's enterprise value -- its stock-market value plus outstanding debt, minus cash -- is a mere 12% of its more than $7.3 billion in annual sales. The ratio of enterprise value to sales for nearly all other publicly traded supermarkets is 25% to 40%. At the same time, Winn-Dixie now has a much stronger balance sheet than its peers.

The stock is cheap because Winn-Dixie's profit margins are low. Its earnings before interest, taxes, depreciation and amortization amount to less than 2% of its revenues, compared with an average of more than 4.5% for its peers. As Winn-Dixie continues to remodel stores and increase sales, we think its profit margin could at least double over the next couple of years. Such an increase would likely result in the share price at least doubling as well.

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Two added bonuses: Winn-Dixie could be a takeover target, and it still has $550 million in loss carry-forwards, which will reduce its taxes for many years.

Another favorite stock is Delia's (DLIA), a tiny retailer with a strong balance sheet. Delia's operates retail stores aimed at teenage girls, and it also owns and operates a successful direct-marketing business. The company's new leaders run a tight ship, and they continue to develop brands that connect with Delia's target market.

By the end of Delia's fiscal year, which ended February 2, the company should have had no debt and some $75 million (or $2.40 per share) in cash. With the stock at $2.25, we can essentially buy this fast-growing retailer for free. Moreover, it's not unreasonable to think that Delia's market value could one day equal the company's revenues. That would mean a share price of nearly $10.

Columnists Whitney Tilson and John Heins co-edit ValueInvestor Insight and SuperInvestor Insight. Funds co-managed by Tilson own shares of Delia's and Winn-Dixie.