Where to Find Value in a Pricey Market

• Cummins (CMI): Woe is CEO Theodore Solso. After his company dramatically improved and diversified its revenue and profit structure, Wall Street analysts still label Cummins exclusively a deep cyclical, heavy-duty truck company. This year, with a plunge in heavy truck engine sales, Cummins gets a chance to prove otherwise.

  Despite the marvelous job that management has done in improving profitability, "there's more Cummins." The company will only make a 7% operating margin this year, excluding minority joint venture income. No respectable industrial company has such low margins. A more acceptable 9% margin on 2008 revenue plus joint venture income would generate earnings of $15 to $16 per share.

  This wonderfully geographically diversified industrial conglomerate should trade above $200 if it hits my 2008 earnings targets, compared to its current $145 level. Why? Because an expensive market trades for 18 times 2007 estimates and 16.5 times 2007/08 estimates. Cummins' 13 P/E target is appropriate with those valuations.

• ConocoPhillips (COP): At $67, Conoco trades for only 7.4 times my 2007 earnings estimate and yields about 2.5%. I know, this stock has been a dud over the past year, but it remains one of the cheapest stocks in the U.S. market. It has been held back by a few small operational problems and one big reserve-replacement issue.

  At the upcoming annual analyst meeting, CEO Jim Mulva will try to prove that ConocoPhillips can indeed find oil somewhere besides an AutoZone store. Also, the company has reversed its high-spending, acquisitive ways. Its new strategy is to maximize profits and cash flows from all of its new assets and return significant cash to shareholders. I think investors underappreciate the company's true earnings power. A P/E closer to that of Chevron (CVX) would generate a $90 stock price for ConocoPhillips. Only a 10 P/E in an 18 P/E market? It is still Conoco, after all.

So what's the takeaway from this column? Stocks are not cheap -- they're actually rather expensive. However, fundamental conditions do support an expensive market. Stocks can stay expensive for a while longer. Heck, there's no magic ceiling to an 18 P/E ratio, either. Stocks can get even more expensive. When conditions change for the worse, pricey shares will be a risky bet. We do not know when Goldilocks conditions will reverse.

That high valuation level cuts both ways. It also provides an opportunity for major P/E multiple expansion when a cheap company achieves some conceptual appeal in the minds of investors. That is the reason why many analysts and investors have been underestimating appreciation potential in some of their sectors. A cheap stock with a good story, even a traditional value stock, doesn't have to stop working at 12 or 13 times earnings in an 18 P/E market.

It's OK to keep some skin in the game, especially if you invest in solid companies at low valuations. Just remain cognizant of the risk to a market priced for ideal conditions. And ignore the claim that stocks are cheap. There are three proverbial big lies; you can tack this myth on as the fourth.

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