Value investing is one of the most successful money-making 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.
The problem is that companies often get cheap for a reason -- something may be wrong with them.
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, which was a time when most analysts thought Coke's growth prospects looked dim.
Since 1988, Buffett's investment in Coke has earned approximately 14% annualized returns. That's market beating -- and the only reason it's not as impressive as it once was is because Coke has again declined in recent years, as analysts again doubt the brand's power and its growth prospects.
Will Coke stay down for the count this time? Motley Fool Inside Value lead analyst Philip Durell doesn't think so. He recommended the company to subscribers in the January 2005 issue for many of the same reasons Buffett bought in 1988. Coke's situation is just ugly enough to get you a great price on a good company.
The same could also be said for the avian flu threat that has knocked down chicken stocks such as Sanderson Farms
Like these companies, Coke isn't firing on all cylinders right now -- but there are no illegalities and CEO Neville Isdell is focused on spurring future growth. The market will come around.
When ugly is too ugly
But it can get pretty ugly out there on the market. Master small-cap investor David Nierenberg told Fool co-founder Tom Gardner recently that there are two clear indications to steer clear 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 is one stock that Nierenberg was staying away from back in January. Although new management was trying to turn around the business, the company had not yet released any new, reliable 10-Ks or 10-Qs. As Nierenberg wondered to Tom, "[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 these questions, it was impossible to determine at what price Krispy Kreme was a value -- if any.
Then there's the ugly situation that Philip got into when he recommended Doral Financial to subscribers. The leading Puerto Rican mortgage bank had its share price cut in half in the spring of 2005 because analysts charged that Doral was inflating earnings by aggressively valuing its interest-only strips.
Philip had good reason to believe this wasn't the case -- insider buying, for example -- but the recommendation violated Nierenberg's tenets. The accusations surrounding Doral called the trustworthiness of both the management and the financials into question. Those questions have yet to be resolved, and Philip sold Doral from the portfolio in October for a 50% loss.
Doral was a lesson. Yet even with it bogging the scorecard down, Philip's recommendations are still beating the market by four percentage points.
The Foolish bottom line
When you're trolling for values in the market, you're going to come across some ugly situations. Without reliable management and financials, consider the situation too ugly for your dollars.
If you'd like some help separating the ugly from the too ugly -- and it can be tricky -- consider a 30-day free trial to Motley Fool Inside Value. Philip 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 in this article. UnitedHealth is an Inside Value and Stock Advisor recommendation. Coventry Health Care is a Stock Advisor pick. No Fool is too cool for disclosure ... and Tim's pretty darn cool.