Editor's note: A major shift is about to occur in the markets...

During the historic bull market over the past decade, growth stocks have outperformed their value peers. But Extreme Value editor Dan Ferris believes that should change soon...

According to Dan, the "Golden Age of Value Investing" is upon us. And for investors focused on buying great businesses at cheap prices, it could be one of the most profitable times they'll ever see in the markets.

So this weekend, we're sharing an exclusive two-part interview with Dan. Today, he explains the "clear historical rhythm" between growth and value stocks... why market corrections are a good thing... where he thinks we are in the current bull market... and the "five financial clues" he looks for in every business he recommends...

The Five Financial Clues to Finding Your Next Winning Stock

An interview with Dan Ferris, editor, Extreme Value

Sam Latter: Dan, as longtime readers know, you're our in-house value-investing guru. You've gone on the record to say that the "Golden Age of Value Investing" is upon us. What do you mean by that?

Dan Ferris: First, I want to make it clear that I think we're in the very early days of that, and I see that development in just a couple of sectors right now.

But take, for example, the Russell 3000 Growth Index and the Russell 3000 Value Index. There's a clear historical rhythm where one index tends to outperform the other for several years, and then they switch.

As you might guess, in the late 1990s, growth outperformed handily until the dot-com bubble burst. Then people became disenchanted with all those high-growth technology and telecom-type companies. What was left was all the stuff that had gotten cheap: mining and industrial companies, housing, homebuilders, mortgages, banking, all that stuff.

The cheap stuff outperformed for a while until Wall Street took those super-safe assets and turned them into toxic waste. The U.S. 30-year mortgage was ripe to be turned into toxic waste because everybody believed it was this wonderfully safe asset. That created a bubble that blew up, and then nobody wanted to own the toxic waste anymore... So they turned back to growth stocks.

Since about 2009, we've seen the growth index outperform the value index. In 2016, that situation reversed briefly when the market fell a bit. But it soon switched back, and growth came roaring back. Although we're still in this period where growth is outperforming value, we're starting to see green shoots.

Sam: Where in today's market are you starting to see value?

Dan: Mining stocks got absolutely crushed in a brutal bear market starting around 2011 and continuing through early 2016. They've since generated some really good value. Of course, retail got crushed in 2016.

If and when we get another bear market, I think we'll see a period of about seven to 10 years of what I would call the new Golden Age of Value Investing.

Sam: You're about as contrarian as it comes. When stocks fall, you cheer. At the end of last year, the market went through a 19.8% correction – a hair short of official bear market territory. While most investors were panicking and wondering if the bull market had finally ended, you didn't even flinch. Why do you think market corrections are a good thing?

Dan: That pullback didn't do a lot as far as valuation goes. It didn't make stocks much more attractive because they're really stretched right now. It wasn't some kind of wonderful meltdown that gave us lots of opportunities. Having said that, you're right... Equities don't become attractive until you can buy them at a fair price.

When prices fall, if the business isn't in big trouble and you have the ability to hold the equity for long enough for the situation to play out, that's a great value setup. We didn't get it at the end of last year, so we've been on the hunt for larger trends, like what we've seen in bombed-out sectors like mining and retail.

Sam: To your point, everywhere you looked – whether you were reading the Wall Street Journal or turning on CNBC – you would've thought we were in a full-blown market crash. That just shows how calm the markets have been for the most part over the past few years and how everybody has sort of forgotten that stocks don't move in one direction forever.

Dan: Yeah. This wasn't a sufficient enough pullback to really do enough damage to investor sentiment and get people selling heavily and running for the exits. But I think that'll happen in the next couple of years.

Sam: Speaking of that, our readers have heard a lot from Porter and Steve Sjuggerud about their thoughts on this bull market.

Porter has been writing about the huge amounts of debt in the student- and auto-loan markets that are going to turn bad, which will lead to a big bear market.

And Steve has gone on the record to say that we'll experience the "Melt Up" before we experience the "Melt Down," when the bull market finally runs out of steam.

But readers haven't really heard many major market predictions from you. Where do you stand on exactly where we are in this bull market?

Dan: I think we're in the last innings. That's not really a controversial viewpoint because the bull market has gone on for so many years and the valuations are so stretched. Hardly anything is attractively priced today. I agree with some of what Porter and Steve are saying, but the reason you haven't heard predictions from me is that I don't make them.

I do expect equities to perform poorly from here because in the past, when they're reached valuations like this, they've performed poorly. They're priced for lousy returns. All I need is to know what's attractively priced for a good long-term return. By and large, that isn't U.S. equities or bonds today.

Sam: You've told readers for years to "prepare, don't predict."

Dan: Absolutely. I've said that over and over again. It simply means avoiding what is unattractively priced. Don't be afraid to hold cash for another few years. Sell short shares of deteriorating businesses, preferably in industries that are under a lot of pressure. And always buy deep value where you find it.

As long as you have a good margin of safety, you're approaching value investing in the right way. Whenever we find an appropriate margin of safety and everything else lines up, we aren't afraid to recommend it. But lately, that has been harder to find, so we've been recommending holding plenty of cash while we wait for those opportunities.

Sam: How do you measure the margin of safety in an investment?

Dan: Margin of safety is simply the difference between what you think a business is worth and the price you're willing to pay. You'll see value investors like the folks at Harris Associates who run the Oakmark Funds. They've consistently said they want to pay two-thirds of intrinsic value, so basically 33% margin of safety or a 33% discount to true value.

You need this margin of safety because people aren't perfect. If you estimate that a business is worth $100 a share and you pay $100 for it, maybe you're wrong and it's really only worth $80 a share, and the market corrects. At that point, you either have to admit you made a mistake and get out or wait to get a positive return.

On the other hand, if you determined something was worth $100 a share but you refused to pay more than about $65 a share for it, that allows you to be a little or even a lot wrong and still come out on top.

Sam: Longtime readers know that back in 2011, you recommended shares of alcohol giant Constellation Brands (STZ). It went on to become one of the best-performing recommendations in Stansberry Research history. You closed the position five and a half years later for a gain of 631%. What was it about Constellation Brands that stood out to you as a fantastic investment opportunity when you recommended it?

Dan: First of all, I didn't know anything. But a couple of things were really attractive to me. One was that it was in a good industry. The alcoholic beverage business has strong margins, generates plenty of cash, and doesn't require huge amounts of capital to keep it going. Plus, consumers have strong brand loyalty, which allows these companies to charge premium pricing and keep the margins thick for a long time.

Constellation was also trading at a really cheap valuation. It was trading at something like six times trailing free cash flow.

At the time, management was divesting assets and repositioning the business. That's not always easy, and sometimes a company has to sell some of its brands. When we found Constellation, management was making good decisions but it had fallen out of favor with the market.

Sam: Of course, Constellation was just one of the big winners you've had. You also recommended household-goods maker Prestige Brands, which ended up returning more than 400% and also sits in the Stansberry Research Hall of Fame.

In fact, the Extreme Value model portfolio has multiple triple-digit winners right now. What sets you apart from other folks who recommend stocks for a living?

Dan: The most important thing – and what I think is the easiest competitive advantage for an investor – is a longer-term viewpoint. Most people simply don't want to wait, and that's a big problem. They want to churn their account and trade in and out of things. They expect to make a lot of money quickly. But an equity is an open-ended, long-term type of investment. Compounding happens over a long time. Expecting to quickly make a fortune in equities is irrational.

Having said that, we're also extremely selective in Extreme Value. We've made far fewer recommendations than most of the folks who have been in the business as long as I have. I've been writing Extreme Value since 2002. Over that time, I've made 136 recommendations. Most newsletters that have been around that long have made hundreds of recommendations.

I'd be shocked if the average holding period of those other newsletter writers was even one year. Our average holding period is about three years. Our longer-term viewpoint is a huge advantage.

Sam: Because you're so selective, you're able to put a ton of research into each investment recommendation you make. And one of the reasons you've been able to find such high-quality investments is because you've identified five traits that most great businesses share. Can you walk us through the "five financial clues"?

Dan: Sure. But let me be clear... not every stock in Extreme Value has to have all five clues. That said, there are five important things that all investors should know about every stock they buy.

The first one is free cash flow. The value of a business comes from its ability to generate cash over and above what it costs to run the business, and the ongoing investment necessary to maintain and grow the business. Free cash flow is a measure of that.

The second clue is consistent profit margins. Some people confuse that with "thick profit margins," but what I really mean is a company with profit margins of a consistent thickness. For example, warehouse-club store Costco Wholesale (COST) consistently has net margins of 1.5%. Those aren't thick, but they are consistent, and that's an anomaly.

In capitalism, a consistent profit margin will attract competition. A company will come along and say, "If you'll take 20% margins, I'll do the same thing and charge 15% for it." Eventually, profit margins can be winnowed down to 0%. If you find a company that has maintained a consistent profit margin, it's unusual and deserves your attention.

The third clue is to have a really good balance sheet. Companies can do this in one of two ways. The first is by having a ton of cash and little to no debt. Companies like Apple (AAPL) or Microsoft (MSFT) have between $100 billion and $250 billion of cash and a lot less debt. Apple has tens of billions of dollars' worth of debt, but it has $245 billion in cash. That's more than enough to extinguish its debt and still have a ton of money left over.

The other way to have a great balance sheet is for a company to have a consistent stream of earnings that can cover its interest payments at least five times over. Discount retailer Walmart (WMT) has been a good example of that. It has generally covered its interest payments between six and eight times the last several years.

Sam: OK, so we've covered three of the five clues. What are the last two?

Dan: The fourth financial clue is shareholder rewards. We look for companies that pay dividends and buy back shares. Over time, I've learned to be more suspicious of share repurchases because most companies will buy their shares back regardless of how expensive they are. Dividends can impose a kind of discipline on a business where they are essentially paying out all the capital that they cannot put to work in the business. That makes sense, and it tends to generate decent returns for shareholders, even after taxes.

Buffett says he doesn't want to pay dividends because the money is taxed coming into the corporation and it's taxed again going into the shareholder's pocket. But even so, if you look at the history of the S&P 500 Index or the Dow Jones Industrial Average, returns on equities over the long term have been 30%, 40%, 50% in dividends alone. Even after you take taxes out of that, it's still a good number that treats investors well. And it's always good to keep corporate executives disciplined.

The last of the five financial clues is return on equity. If a business were a bank account, return on equity is the interest rate the business earns on all the money it leaves in its account. Again, consistency here is key. Return on equity doesn't have to be especially high, but it should be consistent. That means a company can keep reinvesting in its business and earning that rate of return.

Sam: What's your benchmark for an impressive return on equity?

Dan: Generally speaking, I like to see return on equity at no less than 20%. But if it's in the 15%-19% range and it's a high-quality business capable of earning a consistent return on equity, a consistent profit margin, and gushing free cash flow, that can be a good opportunity, too.

The best situations are when you find companies that require tiny amounts of capital – just a few million bucks here and there in any given year – but can generate tens of millions and potentially $100 million or more in free cash flow in the next several years.

We have a couple companies like that in the Extreme Value portfolio. When you can find a situation like that, the return on equity gets to be in the thousands of percent. It's crazy, and it's wonderful for investors. The numbers look unbelievable, but they're real.

Those are the five financial clues. It's a way to gauge a company's ability to consistently provide investors with an adequate return over a long period of time. And it's a way to gauge risk in every investment you make.

Editor's note: Dan's unique approach has led Extreme Value subscribers to gains of 631% and 406%. But he believes he's found a company that could blow those gains away... And though it's currently trading pennies above his maximum "buy" price, he predicts patient investors could be sitting on a 20-bagger over the next few years. Get the details here.