Special-Situations Investing

This article was originally written by Bill Mann, but has been updated by our Foolish staff. The words below reflect Bill's tone.

Tom Gardner invited me to provide a stock idea for the Motley Fool Hidden Gems small-cap newsletter in October 2003. Given how much I love "special situations" -- companies that are involved in some sort of restructuring, turnaround, or other conditions that provide opportunity for investors -- I focused on two such opportunities: commercial oven maker Middleby (Nasdaq: MIDD) and coin-counting kiosk company Coinstar (Nasdaq: CSTR).

Both had undergone recent changes to address problems with their businesses, causing investors to flee their stocks. Middleby was refocusing its business on ovens, and Coinstar was responding to the loss of Safeway (NYSE: SWY), one of its largest customers. I ended up picking Coinstar, which has since increased more than 120% in value. Unbeknownst to me, Tom had seen the same thing with Middleby that I had. Good choice. It's been a five-bagger since.

Short-term news, long-term world
Special-situations investing works because so many of our fellow investors tend to focus on short-term problems, without considering that the overwhelming majority of them are fixable. The world's largest restaurant company, McDonald's (NYSE: MCD), saw its shares drop nearly 70% in 2002, as marketing problems stemming from the contemptible "Smile" campaign unearthed the need for a widespread revitalization of the company. McDonald's is one of the most widely followed companies in the world, but investors treated its restaurant problems as a permanent impairment to the company's value. Meanwhile, Mickey D's real estate value alone was worth more than its market capitalization.

That's what I call a "fat pitch." If you ignore the headlines, and ignore Wall Street's sell-what's-hot ethos, you'll find opportunities like this one. The end result for McDonald's has been a 350% rise in its share price in less than four years, and a recently generated $180 million in cash from its spinoff of a portion of Chipotle Mexican Grill (NYSE: CMG) (NYSE: CMG-B).

Special and boring
Think about that for a moment. We're not talking about the greatest laser technology to come down the pike. We're talking about hamburgers and burritos, and big, big gains for investors who stayed the course.

What other special situations exist? One of the great tricks to special-situation investing involves seeking out companies that are being penalized for problems that affect their entire industry, though the company itself may have a perfectly reasonable grip on these issues. Continental Airlines (NYSE: CAL) offered investors an opportunity in airlines when people saw the bankruptcies at several of its brethren and said, "Stay away from the whole industry." Just how bad was it? Continental has gone up more than 200% in less than 24 months.

The Foolish bottom line
Do special situations exist today? You bet. In fact, I highlight one such opportunity in an issue of Hidden Gems. You might also want to look at companies like Red Robin Gourmet Burgers (Nasdaq: RRGB), which has outstanding free cash flow and a significant growth trajectory in the burgeoning gourmet burger and sandwich segment. It's recently come under pressure following an internal audit that uncovered some shady transactions by its now-former CEO. This company turned in $78 million in operating cash flow over the past 12 months, and it has paltry debt. Special situation? Well, the market certainly thinks this company's going in the wrong direction.

I can't say that I agree.