Ugly Stocks, Great Opportunities

Value investing is one of the most successful moneymaking strategies in the market. Master investor Warren Buffett, for example, has earned greater-than-20% annualized returns for the past 40 years by buying good companies when they're cheap.

Unfortunately, companies often get cheap for a reason: Something may be wrong with them -- or, as we’re seeing today, with the environment in which they operate.

The ugly
One of Buffett's best investments was taking a major stake in Coca-Cola in the fall of 1988 -- in the aftermath of 1987's Black Monday crash, when most analysts thought Coke's growth prospects looked dim.

Since 1988, Buffett's investment in Coke has earned approximately 12% annualized returns, plus dividends. That's market-beating -- and quite impressive.

Well, the market now seems to largely doubt the growth prospects for most of the companies trading out there today. This is either the “end of days,” or a promising long-term buying opportunity. For example, asset managers such as Legg Mason (NYSE: LM), Calamos (Nasdaq: CLMS), and Pzena (NYSE: PZN) have been destroyed on fears of both massive client redemptions and a market downturn that will sink their once-promising track records. But the stock market will be back, and the best asset managers will be among those who profit most when that happens.

Furthermore, there’s cabinetmaker American Woodmark (Nasdaq: AMWD), which has been hit by slackening housing demand. But if we’re all stuck in our houses for a few more years, perhaps we’ll see strength in the home-remodeling space when consumer confidence returns.

Then there are the rising fuel prices and the deteriorating shipping climate that have crunched truckers Old Dominion (Nasdaq: ODFL) and YRC Worldwide (Nasdaq: YRCW). These companies may struggle right now, but lots of stuff still needs to get cross-country via roads.

When ugly is too ugly
But it can get pretty ugly out there on the market. Master small-cap investor David Nierenberg has told Fool co-founder Tom Gardner that there are two clear signs of an ugly situation. First, "If we see an ethical blemish on the part of the incumbent management or the board, we are absolutely not interested. The second is: If we cannot trust or understand their accounting, we are absolutely not interested."

Krispy Kreme Doughnuts is one stock that Nierenberg was avoiding when Tom interviewed him in 2005. Although new management was trying to turn around the business, the company had not yet released any new, reliable 10-Ks or 10-Qs. (It finally did so in April 2006.) As Nierenberg wondered to Tom before those releases, "[Has] this company ever earned a real profit? And what return on invested capital has it actually made at the newly opened stores?" Without answers to those questions, it was impossible to determine in 2005 at what price Krispy Kreme was a value -- if any.

Facing enormous write-offs and government ownership, financial firms may be another segment today that investors should bother trying to understand.

The Foolish bottom line
When you're trolling for values in the market, you'll find some ugly situations. Without reliable management and financials, consider the situation too ugly for your dollars.

Separating the ugly from the too ugly can be tricky. If you'd like some help, consider a 30-day free trial to Motley Fool Inside Value. The Value team specializes in finding ugly situations ripe for a profitable turnaround -- whether it's because of new management, new strategies, or new events. Click here to learn more.

This article was originally published on Jan. 31, 2006. It has been updated.

Tim Hanson does not own shares of any company mentioned. Coca-Cola and Legg Mason are Motley Fool Inside Value recommendations. YRC Worldwide is a Hidden Gems Pay Dirt selection. The Motley Fool owns shares of Legg Mason. No Fool is too cool for disclosure.