Hero or Zero?

A value investor's toolbox should be filled with many different tools. That's because undervalued opportunities can 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 just 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
There are certainly some typical situations that become staples in the value investor's toolbox. Taking advantage of undervalued growth is one. Sometimes, good companies experience short-term slowdowns and require some tuning up. During that time, 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 has substantial problems that require 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 a bright blaze-orange sticker bearing bold, black letters on it reading, "WARNING! Use with extreme caution!"

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

Option plays are very risky and require an informational edge before you should even consider making a purchase. The Inside Value team wants to make sure you understand that none of the companies discussed are investment recommendations or endorsements. They are merely 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 there's a catch: There's really 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 $42 million in sales but consumed $32 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 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 telecommunications boom in the late 1990s.

PortalPlayer, which was acquired by NVIDIA (NASDAQ:NVDA) late last year, makes systems-on-a-chip for personal media players, primarily Apple's iPod. Last April, the company received notice that Apple had decided not to use a next-generation PortalPlayer product in some of its newest flash memory-based iPods. The stock fell hard on the news.

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, it's just like 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 at all. 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" types of situations, and it should be a small one. But it's important to talk about these types of ideas, so that you can be ready to use this tool should you 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, is a current recommendation.

To see what other types of tools Inside Value lead analyst Philip Durell uses, be his guest free for 30 days. You'll enjoy complete access to all of the recommendations, the community, and even bonus material. That's a no-lose proposition.

This article, originally published on June 6, 2006, is one of a series. The rest of the stories are here.

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Fool editor David Meier does not own shares in any of the companies mentioned. NVIDIA is a Stock Advisor recommendation. The Motley Fool has a disclosure policy.