Hero or Zero?

A value investor's toolbox should be filled with an array of tools. That's because undervalued opportunities come in many different forms.

As the proverb goes, "Variety is the spice of life." And believe it or not, value investors love variety, too. We're not focused only on stocks with low price-to-earnings or low price-to-book ratios. Far from it. In fact, the value situation we're going to talk about should blow that stereotype right out of the water.

Old reliable
Some typical situations become staples in the value investor's toolbox. Taking advantage of undervalued growth is one. Sometimes good companies experience short-term slowdowns and require tuning up. That's when the market, in a flare-up of manic depression, drives their stock prices lower than the value of their growth prospects.

Another value-investing favorite is the turnaround. You see this when a company with substantial problems requires a major overhaul. These opportunities can be especially rewarding if you can get your analysis done while the company is "dead money."

Shiny and sharp
One tool doesn't come out very often; it stays in a tamper-resistant container, adorned with an arresting, blaze-orange sticker that reads: "WARNING! Use with extreme caution!"

This tool targets the "option play." No, it has nothing to do with "put" or "call option" securities. It is a special situation for a common stock. Here's a disclaimer before we define it:

Option plays are very risky and require an informational edge before you even consider making a purchase. The Inside Value team wants to emphasize that none of the companies discussed below are investment recommendations or endorsements. They are examples to illustrate the concept.

Do your homework
An option play refers to a situation in which a company has lots of cash supporting its current value. But here's the catch: There is no such thing as free money in the stock market.

Option plays typically involve two scenarios: Either the business can use that cash wisely to generate future sales, or it can burn through the cash before it generates significant sales. Thus, an investor is paying for an "option" that the business will succeed, and the option's price accounts for the cash on the balance sheet. As I said, it is a risky play, but it can present a mispriced-value situation because of all the uncertainty.

So I built a screen to find some option plays. Here's what it gave me.

What do they do?
ActivIdentity provides digital security technologies that allow customers to perform secure transactions and secure data access. Last year, the company generated $53 million in sales but consumed $26 million in cash from operations.

Leadis Technology makes color display drivers for mobile devices such as cell phones. Last year, sales were down significantly after a customer pushed out a launch date.

Sycamore Networks sells optical-networking products. It was very popular during the telecom bubble in early 2000, when its sales rose to almost $380 million. But after the access to capital dried up and investments in the optical-fiber infrastructure plummeted, so did Sycamore's sales. Sales have picked up again.

InfoSpace has two businesses. It provides mobile content, plus online search and directory services. InfoSpace was a darling of the telecom boom in the late 1990s.

Know the odds
As I mentioned, before you even think of anteing up for an option play, you must have an information edge over the market. Otherwise, you're buying a lottery ticket -- you'll have no control of your destiny. You'd be better off flushing your money away.

And even if you do have good information and are able to come to a reasonable conclusion, you need to control your risk further by allocating only small amounts of capital to such investments, if any. That's because the expected returns are skewed -- there is a high probability of losing most of your money against a smaller probability of making lots of money. Needless to say -- but I'll say it anyway -- putting 50% of your portfolio on a bet like this would be foolish with a small f.

Use your tools wisely
There is a place in your portfolio for these "hero or zero" situations, and it should be a small one. But it's important to talk about these ideas so you can be ready to use this tool if you ever come across the right situation.

The beautiful thing about value investing is that we have lots of options, and the majority of your portfolio should be allocated to the less risky ones. That's where Inside Value can help. While we search for option plays, we also search for undervalued growth and turnarounds: Tyco (NYSE:TYC), for example, was a turnaround recommendation.