As we head into the final trimester of 2012, it’s time to take a fresh look at where we stand in terms of the stock market and the economy. So far this year, the S&P 500 has delivered a solid 12% gain, despite countless headwinds in place.

That kind of return shouldn’t be sneezed at: strategists suggest that 6% to 7% is a reasonable expectation for annual gains. To some, this means we’re living on borrowed time. Sure, the market can still post further gains, but it’s crucial that your preserve this year’s gains in case we hit the (likely inevitable) bout of profit-taking.#-ad_banner-#

This doesn’t mean it’s time to run for the hills. It just means you should be adding inexpensive stocks to your portfolio while lightening up on more expensive ones. We’ve decided to make the task a bit easier for you by ferreting out the cheapest stocks in the S&P 500. What’s cheap? Well, we can use several measures and see how these 500 companies stack up. By the end, we can even arrive at our destination: the cheapest stocks in the S&P 500.

It’s not hard to find stocks sporting reasonable price-to-earnings (P/E) multiples. Roughly 40% of the stocks in the S&P 500 trade for less than 12 times projected 2013 profits. You won’t find many tech stocks in this group. Instead, the list is dominated by industrial firms, financial institutions and utilities.

Of course, David Dodd and Benjamin Graham, the grandfathers of value investing, would tell you that net income doesn’t always tell you the real value of a business. In the first half of the 20th century, they were much more concerned with a company’s balance sheet. They simply wanted to know the value of a company’s assets in the real world. If the balance sheet had even greater value than the stock market value, then it was a simple decision to buy. At least until the stock traded up to book value.

Unfortunately, the only stocks that trade below book value (which represent the net assets on the balance sheet after liabilities are subtracted) are usually facing a bout of distress. So to maintain solid, quality companies in our screening process, it’s wise to let any companies in that trade for less than 1.5 times book value.

Looking for companies that trade for less than 12 times projected 2013 profits and less than 1.5 times book value, we’ve narrowed the list down to 51 companies, or about 10% of the S&P 500. And now that we’ve measured these companies in terms of income statement and balance sheet, it’s time to look at third financial statement — the cash flow statement.

Free and clear
While many investors gauge a company’s health by its operating cash flow, you need to go a step further. You need to look at how much cash flow is left — after you’ve deducted for capital spending. In other words, the cash that ends up on the balance sheet when all internal investments are made. In my view, free cash flow is the single most important gauge of a company’s health.

Many companies are valued at around 15, 20 or even 25 times fee cash flow. It’s harder to find stocks that sport very low free cash multiples. Yet these are really the kings of value investing. Think about it: if a company trades for around eight times free cash flow, then this means its entire market value can be earned back in just eight years. Any residual value of the business after that is pure upside.

Well, we found 23 companies in the S&P 500 that trade for less than 12 times projected 2013 profits, less than 1.5 times tangible book value, and less than 10 times trailing free cash flow. Of these 23 firms, 10 of them are banks. And it may be wise to exclude banks from these discussions. With ongoing legal proceedings regarding the mortgage mess and LIBOR as well as the still-unresolved crisis in Europe that could hamper global financial markets, these companies possess more risk than a typical value stock.

What’s left? We have 13 companies, all of which are worthy of further research, simply because they sport some terrific numbers. Though they don’t necessarily all possess huge near-term upside, they should be steady gainers over the long haul, thanks to that prodigious free cash flow. Equally important, the downside support — by these measures — is surely impressive.

If Graham & Dodd were alive today, then they’d likely single out seven stocks in this group for special attention: insurers Assurant (NYSE: AIZ), Comerica (NYSE: CMA), Loews (NYSE: L), Metlife (NYSE: MET), Prudential Financial (NYSE: PRU), Hartford Financial (NYSE: HIG) and Unum Group (NYSE: UNM) — all of which trade for less than tangible book value. The fact they also represent value by other measures is just icing on the cake.

Risks to Consider: These insurers hold many financial instruments on their balance sheets, so a major global economic meltdown could erode book value.

Action to Take –> Insurers remain in the doghouse because low interest rates are hampering their returns on investment. They are likely to appreciate only steadily in the near-term as free cash flow further fattens their balance sheet, but an eventual rising interest rate environment should help propel them well higher.