Catching Rising Stars

Generating big returns in the stock market is deceptively simple: Avoid stocks that are too expensive, and buy stocks that are bargain-priced.

So just how do you do it? At Motley Fool Inside Value, we look for trends in a company's return on invested capital (ROIC), which can be broken down two ways:

• ROIC = (net operating profit after tax / sales) * (sales / capital), or
• ROIC = (margins * capital velocity)

Using these two figures, the Inside Value team puts companies into one of the categories below:

To beat the market, we try to avoid companies moving toward "Value Destroyers," and we try to buy companies moving away from "Value Destroyers." Let's dig a little deeper and look at some real-life examples.

Value Destroyers
If a company earns a return on invested capital less than its cost of capital, it destroys value -- which definitely doesn't make share prices rise. Here are two prime examples:

A company's ROIC often declines because of shrinking margins. Take Callaway, the golf club manufacturer, and EDS, the information-technology consulting giant. Each has a decent sales/capital ratio greater than 1.75. However, neither company currently has net operating profit margins (after tax) greater than 3%.

As you can see from the table, the market doesn't take kindly to companies that become Value Destroyers. Not surprisingly, the Inside Value team tries to avoid them.

Regaining value
We just showed how the market snubs companies with declining ROIC. The companies destroy value, and we lose money. So stay away! But don't stray too far. Some of these companies may be Value Destroyers only temporarily, giving astute value investors the chance to get in on the ground floor. Here are four examples of companies that shed the Destroyer moniker:

All four of these businesses experienced hard times along the way. In fact, Guess?, Apple, and SanDisk swung from being profitable to losing money. During that time, the companies' prices dropped, as investors sold shares in the face of value destruction. Nike was well on its way to becoming a Value Destroyer, too, but it didn't quite make it. Still, its stock was hit hard.

Fortunately, all of these companies turned their businesses around. Management was able to work through the tough times, restore profitability, and increase returns on invested capital. As you can see from the fourth column, the market rewarded these firms' performance.

Successful turnaround secrets
Investing in turnaround situations can be tough, especially on the psyche. But we want you to profit from turnarounds without getting stung by a Value Destroyer. To do so, you must:

1. Understand the companies
2. Be able to go against the crowd
3. Be patient

Without a good understanding of how a business works and how well it competes, it's difficult to know whether its losses will continue. Even if you understand the company, humans don't like to stand out from their peers; consensus is comfortable. But as a value investor, you must be willing to do your own thing, not follow the crowd. Furthermore, you must withstand the ups and downs of the market. Turnarounds don't always happen smoothly. Resist the temptation to give up on a situation too quickly just because the market price is fluctuating.

Find better bargains
At Motley Fool Inside Value, advisor/analyst Philip Durell carefully examines each situation, is comfortable owning things others don't, and keeps subscribers aware of what's going on at each company he profiles. That's exactly why he recently recommended Rent-A-Center (NASDAQ:RCII); the company was once on its way to destroying value, but now it's turning things around.

As a bargain hunter, we know you want to protect and grow your capital. Philip invites you to be a guest of the Fool's Inside Value newsletter free for 30 days. As his guest, you'll see how he beats the market by catching rising stars and creating -- not destroying -- value for subscribers.

This article was originally published on March 24, 2006.

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At the original time of publication, David Meier owned shares of Nike, but did not own shares in any of the other companies mentioned. The Motley Fool has a disclosure policy.