The Next Big Bargain

The market offers bargain opportunities every day. You won't always know what the opportunity will be, but finding one can supercharge your portfolio.

Master investor Peter Lynch said that one advantage of running Fidelity Magellan (FMAGX) was its charter. It was a capital appreciation fund, giving Lynch the flexibility to buy in any investment situation. Big or small, constant or cyclical growth, asset plays or turnarounds -- you name it, Lynch bought it.

While we should follow his example and look for the best opportunities in any form -- growth stories, turnarounds, misunderstood stocks-- one type of investment can be particularly rewarding.

Limited-time-only sales
The best companies grow steadily year after year, right? Wrong. Great companies have plenty of miscues along the way, but the truly great companies recover.

If the initial step on the road to great returns is to invest in great companies, we must first know what it takes to be great. Read Built to Last or Good to Great by Jim Collins. Read Common Stocks, Uncommon Profits by super-investor Philip Fisher. Another master, Warren Buffett, offers his thoughts in his annual chairman's letters. Read those, too. Trust me -- you'll learn what makes a company great.

We'd all be rich if the only thing investors had to do was identify great companies. The second key, as Buffett advocates, is to buy them when they're on sale. And when do they go on sale? When there are problems.

At Inside Value, we know it's difficult to purchase companies surrounded by negativity. But the market offers the opportunity for big rewards, if those problems are only temporary. Here are some recent examples of great companies selling at discount prices for a limited time:

30% off
2004 started off as a good year for Hewlett-Packard. In 2003, the company was restructuring to become more cost-competitive with Dell and beating earnings in the process. As such, the stock was gaining favor again.

Despite raising guidance for 2004, several patent-infringement lawsuits, as well as continued price erosion on computer hardware, created enough uncertainty to cause some investors to sell.

Fortunately, a strong printer business and effective cost-cutting helped the company beat estimates in August 2004, sending the stock higher. It also didn't hurt that the company doubled its share-buyback program to $2 billion.

50% off
It should be no surprise that hard-disk maker Western Digital's fortunes should closely follow the computer industry. But it is a coincidence that HP and Western Digital's lows occurred on the same day.

What drove Western Digital's stock price down? Revenue growth lagged unit growth. It's never comforting to lack pricing power, even as the level of technology is increasing. But such is the nature of this difficult industry, where Western Digital was up against competitors like Seagate Technology (NYSE:STX).

But still, at its low, the company was trading at an enterprise value-to-EBITDA ratio of just greater than four, a historical low for a company with a pretty good balance sheet and a history of growth.

90% off
The promise of deregulated energy markets from 1998 to 2002 had energy companies gobbling up newly available capital to build new, natural gas-fired power plants. As an engineer in GE Power Systems' unit at the time, I can testify that we couldn't sell turbines fast enough to companies like Calpine and the like.

Then access to capital dried up, and Enron's house of cards fell apart, taking lots of otherwise solid companies down with it, like Williams Companies (NYSE:WMB), AES, and TXU. It certainly didn't help that TXU cut its dividend by 80%, saw a slew of securities-fraud lawsuits and an SEC inquiry into the dividend cut, and lowered its 2002 guidance.

But TXU's assets were real and continued to produce cash. The market seemed to overlook the fact that these assets were valuable. Investors who saw the value of the assets have been amply rewarded after the market realized its mistake.

Today's sales
Within the market, there are plenty of underappreciated, unloved, and misunderstood businesses. Add the right catalyst, and you've got opportunity.

USG (NYSE:USG) has had plenty of ups and downs over the past few years. Actually, with the recent slowdown in the housing market, it's had plenty of ups and down over the past six months.

When you're the low-cost leader in a boring yet very important industry, and your stock price is down, lots of value investors get interested: Warren Buffett, Bruce Berkowitz at Fairholme Capital Management, and Wally Weitz to name a few. They must -- as we do at Inside Value -- continue to think the stock is cheap ... and smell opportunity.

On sale tomorrow ...
Who will be tomorrow's next big bargain? That's what Philip Durell and his Inside Value team are dedicated to finding out. If you'd like to take a look at the stocks we're recommending today, click here to join our community free for 30 days. There's no obligation to subscribe.

This article was originally published on June 24, 2005. It has been updated.

Retail editor and Inside Value team member David Meier owns shares of AES but does not own shares in any of the other companies mentioned. Dell is both an Inside Value and a Stock Advisor recommendation. USG is also an Inside Value pick. The Motley Fool has a disclosure policy.