Martin Sass, founder of M.D. Sass, uses his many years of market experience to fuel his bottom-up, forensically researched stock-picking.

Sass personally runs the $1.2 billion-in-assets M.D. Sass Relative Value Equities, a long-only large-cap value strategy. His contrarian bent helped him grow assets of Relative Value Equities throughout the financial crisis (they are up from $1.1 billion on April 30, 2007) despite big drops in the broader market. The fund charges a management fee of 1% per annum on the first $10 million, and a sliding scale thereafter.

He is primarily a bottom-up stockpicker who uses intensive forensic research to identify trends—a method honed as director of Argus Research's Special Situations group in the mid-1960s.

There Sass is credited with calling the top of the boom in color-TV sets. On a cab ride from Chicago's O'Hare airport to visit Motorola, his driver told him he had been laid off from the electronics giant because there was a glut of color-TV tubes. A follow-up visit to a Motorola supplier confirmed there was a problem. Sass wrote a sell recommendation on the entire color-TV group, just before the bottom fell out.

Such gumshoe research has helped him gain an edge by unearthing catalysts for change, identifying and quantifying the difference between market perceptions and reality and discovering new drivers of earnings. For Sass, a Brooklyn College grad with a degree in accounting, the most important financial metric is free cash flow, because accounting gimmickry can obfuscate real earnings. Free cash flow gives a more accurate view of corporate health, he says.

Sass likes Chicago Bridge & Iron (ticker: CBI) because the Street doesn't seem to understand that 50% of its earnings come from businesses that are a lot less volatile than traditional engineering and construction. "They are focused on energy, and we think we are entering a boom in new capital spending on energy to meet this need for increasing energy supply," he says. The stock, meanwhile, is selling at a low multiple, has a rising backlog, plenty of new contract awards, and is trading at a big discount to its peers.

"WE THINK THE STOCK WILL TRADE at 12.7 times our estimate for 2011 earnings…that's a 66% increase from where we are today," he says. Chicago Bridge & Iron was recently trading at 20.33, up from his average cost of about 14.40. He sees '10 earnings coming in at $1.88 and '11 earnings at $2.36.

Just recently he bought the out-of-favor slot-machine maker WMS Industries (WMS), which has been under pressure because casinos have been slow to buy new machines. Gamblers, it seems, are feeling the pinch of recession and unemployment. But slot machines don't last forever, and Sass believes the current replacement rate of 40,000 to 45,000 units a year is unsustainable.

"The replacement market should move to a normalized 10-year rate of about 80,000 units a year, which should begin to show acceleration sometime next year," he says. WMS has been taking market share. It was recently trading at 38.92 He sees earnings for fiscal '11 at $2.46 and $3.35 in '12.

In general, Sass' picks need to have the potential to achieve a 25%-plus total return (including dividends) over 12 months or to double in five years. He gets out of a position if its price approaches his target, the position becomes more than 5% of his portfolio or the fundamentals deteriorate.

Relative Value Equities has no desire to mimic benchmarks. It's a focused portfolio made up of out of 25 to 40 high quality out-of-favor stocks that provide greater upside, with less risk, than owning a large basket of stocks. The average market cap is $35 billion. Relative Value's audited and GIPS compliant performance shows a net cumulative return of 75.7% since the beginning of 1999, through June 30th of this year. That compares with a 2.7% cumulative return for the Standard & Poor's 500 in that time. On an annualized basis, Relative Value is up 5% per year in that time, versus the S&P's 0.2%.

Sass likes companies that are good to shareholders: "We look for companies with high free cash flow yields that are most likely to return cash to shareholders via dividends, share repurchases or to pursue cash acquisitions," he says.

A good example is a brand new holding, Yahoo! (YHOO), which he calls the least expensive Internet firm. It has $4.5 billion in cash and no debt, and is planning to buy back billions of dollars of stock over the next few years. Last week Yahoo! reported it had repurchased 63 million shares for $973 million at an average price of 15.40 year-to-date, including July. Plus, the display-ad business on the Internet has significant growth potential, with a 19% increase estimated for 2010 followed by 12% in 2011.

YAHOO!'S SEARCH DEAL with Microsoft is still in its early stages and by 2011 margins should expand as the company offloads major parts of search to the software giant. He expects earnings to be 93 cents in '10 and $1.15 in '11. The stock was recently trading at 14, which gives the shares a price/earnings ratio of 15 times 2011 earnings. But that isn't why Sass thinks it's undervalued: "Yahoo! has no debt and about $10 a share in cash and other semi-liquid assets."

He also recently picked up Tyco Electronics, (TEL), which was spun off from Tyco International four years ago and has transformed itself by consolidating plants and selling noncore businesses. Plus, it's made some shrewd acquisitions. The maker of electronic components recently unveiled a deal to buy ADC (ADCT) for $12.75 per share in cash, or an enterprise value of about $1.25 billion. ADC makes fiber connectors for data switching and other applications. The two can offer solutions for high-speed Internet data, video and voice communications.

"The deal will add 14 cents per share in first full year after closure and 30 cents in the second year. [It has a] free-cash flow yield of more than 10%, dividend yield of 2.5% and P/E below 10 times earnings," he says. He expects earnings for the fiscal year '10 ending in September to be $2.55 and $2.88 in '11. The stock recently was trading at 25.76.

Sass is fairly sanguine about the future. He thinks the S&P 500 will climb to 1243 in the next 12 months, up from the current 1094. Despite the slowing recovery, he thinks a five-year recovery that rewards stocks and leaves Treasury bonds with losses is under way. But the veteran investor isn't about to chase a rally: His license plate reads "MDS 1000." That was where the Dow stood when he opened shop in 1972, just before it plummeted to 573 in October of 1974—not too long before Sass got his first chance to invest with Bernie Madoff.