The Next Big Bargain

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

Master investor Peter Lynch said that one advantage of running Fidelity Magellan was its charter. It was a capital appreciation fund, giving Lynch the flexibility to buy in any investment situation.

And he took advantage of it! 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 -- there's one type that 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 step one on the road to great returns is to invest in great companies, we have to know what it takes to be great. Read Built to Last or Good to Great by Jim Collins. Read Common Stocks, Uncommon Profits by legendary 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 the problems are only temporary.

Here are some recent examples of great companies selling at discount prices for a limited time:

25% off
Office Depot shareholders were on a roller-coaster ride during 2003 and 2004. Early in 2003, things were going pretty well in its battle with Staples (NASDAQ:SPLS) for office-supply retailing dominance. Office Depot was making acquisitions abroad to bolster its international presence. In addition, management confirmed its guidance for 15% to 20% growth. After missing analyst expectations, the company lowered expectations further.

What happened, unfortunately, was that the company reached the top of the big hill. In February, management announced it would miss analyst earnings expectations for 2003. In April, S&P lowered Office Depot's credit rating. In May, management announced it would miss its second-quarter numbers. And finally, in September, management told the market to expect another miss in the third quarter.

Despite the troubling messages, the market hung tough and shares moved to new highs in April 2004. But the market is only so resilient. With the last warning in September 2004, the stock had dropped almost 30%.

Since that time, the company has sharpened its operations. Margins have been rising, and so have returns on invested capital. That's the mark of a great one -- and the reason the stock has rebounded nicely off its lows.

65% off
Like the American consumer, fashion can be fickle. So at the beginning of 2002, when teen and young adult fashion retailer American Eagle began reporting that sales and same-store sales were starting to slow, the market reacted as expected. The stock price dropped fast, down 65% to its low in October.

Fortunately, American Eagle is not your average company. It understands that good products at good prices mean good business for a retailer. And by sticking to its guns during the rough patch in the U.S. economy, it weathered the storm from 2003 to 2004 and saw its ship turn around after Jim O'Donnell and Roger Markfield split from their co-CEO duties. O'Donnell went on to lead the charge as CEO and Markfield became vice chairman and president of the American Eagle division.

Since that time, same-store sales have increased dramatically and margins have expanded. Not only that, but the company is now ready to go after those lucrative 25- to 40-year-old customers with its new MARTIN + OSA concept. The reversal of fortune has led to a reversal of market expectations, sending the price considerably higher.

95% off
I wouldn't necessarily classify Avaya, the telecom equipment supplier spun off from Lucent (now Alcatel-Lucent (NYSE:ALU)), as a "great" company in the traditional sense, but I would definitely call it a fighter.

Shortly after Avaya left the Lucent nest, the telecom industry was derailed because of overinvestment during the tech bubble. And to make matters worse, Avaya's credit rating began to decline as the company looked for new capital to invest in growth. At the time, investing for growth in a declining market didn't look very promising.

But Avaya found a way to turn things around. Sales started growing again and margins increased. More important, return on invested capital rose -- and continue to rise. The market likes increasing returns on capital.

You have to respect a company that can compete ably in a very tough industry after inauspicious beginnings.

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

Today, despite recent volatility, natural gas company Chesapeake Energy (NYSE:CHK) is a new favorite of famed valued investor Mason Hawkins of Southeastern Asset Management. So it looks like Philip Durell, advisor/analyst at Motley Fool Inside Value, is in good company -- he recommended Chesapeake as well and it looks like one of those companies selling for 30% to 40% off.

On sale tomorrow ...
What will be the next big bargain uncovered by Philip Durell and the Inside Value team? The only way to find out is to take a free trial today to see the candidates. Click here to see what they are.

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

David Meier does not own shares in any of the companies mentioned. American Eagle is a Stock Advisor selection. The Motley Fool has adisclosure policy.