Where Opportunity Knocks

"Everything should be made as simple as possible, but not simpler." -- Albert Einstein

Here's a beautifully simple concept from the father of value investing, Benjamin Graham: Over the short term, the market is a voting machine; over the long term, it's a weighing machine.

Graham's characterization of the market helps investors understand how markets typically operate. But by itself, the idea is too simple to actually identify investment opportunities. We have to take it one step further to make it even more useful.

To do that, let's assume that a business' return on invested capital (ROIC) is the key variable the market "weighs" in order for prices to rise over long periods of time. I know there are more, but let's not get too complex just yet.

Here's how we can use those two pieces of information to determine where we can search for investment opportunities:

• Stocks with falling prices and falling ROIC are in turnaround.
• Stocks with rising prices and falling ROIC are in the danger zone.
• Stocks with rising prices and rising ROIC are in for good times.
• Stocks with falling prices and rising ROIC are value opportunities.

Does that make sense? I think so. We expect prices to fall if returns fall, and we expect prices to rise as returns rise. That's the weighing machine in action. Does the market always work like that? No way. Over the short term, the market can act like a voting machine, where stocks' prices and returns move in opposite directions.

Turnarounds
"Falling-falling" can be a fertile ground for turnaround specialists, as long as they understand how the business will get back on track. There's lots of risk here, but lots of potential as well. For every company with a successful turnaround, like Hardee's parent CKE Restaurants (NYSE:CKE), there are ones like Pier 1 (NYSE:PIR) and Rite Aid (NYSE:RAD) that seem to be in perpetual turnaround mode.

Let the good times roll
When prices rise with rising returns, things are going well -- which should make investors cautious, in my opinion. There can be opportunities here, but there is the chance that investors could pay too high a price for a company that will not fulfill the performance required to justify the valuation. And since price determines future returns, we don't want to pay high prices.

Health-care information system developer Quality Systems (NASDAQ:QSII) may be a good example of an opportunity. It generates incredible returns on invested capital because its business doesn't require large, continuous capital investments to generate growth.

As such, its stock returns have been incredible over the past five years.

Danger zone?
Rising prices and falling returns are a dangerous combination I usually try to avoid. That's not a sustainable combination over the long term, if we believe that the market is a weighing machine.

Two interesting examples are Google (NASDAQ:GOOG) and Travelzoo (NASDAQ:TZOO). Believe it or not, their returns on invested capital have been declining for some time (see the table below for ROIC by fiscal year).

However the market, looking forward, continues to see great things for these companies. It must be because their prices continue to rise. Don't get me wrong -- those are incredibly high returns, and their valuations may in fact be too low. But those falling returns scare me enough to stay on the sidelines.

Where opportunity knocks
That's OK. Because on the sidelines, I can look for opportunity in my favorite place: falling prices and rising returns.

In the sections above, the market looks forward and sees great things. But here, the market looks forward but stays pessimistic, despite the great performance. For example, Getty Images' (NYSE:GYI) stock price has dropped more than 50% this year, despite generating increasing ROIC and free cash flow as it builds out its database of photos.

Yes, the digital age of photography has changed the way photos are taken and distributed. There are disruptive forces at play, namely new, community-based distribution channels that could erode its advantage as the largest stock photo service. But when businesses want a high-quality, authenticated photo for their ad, brochure, or other piece of marketing material, they turn to Getty Images.

The Foolish bottom line
Investment opportunities exist everywhere. But if you want to find the best opportunities, concentrate on situations where prices are falling while returns are rising. That could help you catch the market voting incorrectly in the short term, on companies that know how to generate value. You want to be there when the market realizes its mistake -- and bids the price up to a level that justifies its performance.

Do you consider yourself a special situations investor, or are you interested in learning more about these opportunities? Tell us about your interests in our very brief Special Situations Investing Survey. Your comments will help us develop future content to fit your needs.

Motley Fool Inside Value lead analyst Philip Durell is always looking in "the land of opportunity" for great investment ideas. And he's finding lots of them as his recommendations are beating the market. To find out what he's recommending and why, try Inside Value free for 30 days.

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

Retail editor and Inside Value team member David Meier does not own shares in any of the companies mentioned. You can view his profile here. Quality Systems is a Motley Fool Stock Advisor selection. The Fool takes its disclosure policy very seriously.