The Next Big Bargain

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

Master investor Peter Lynch said that one advantage of running Fidelity Magellan (FMAGX) was its charter. It was a capital appreciation fund, giving Lynch the flexibility to buy in any investment situation. 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-- one type of investment 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 the initial step on the road to great returns is to invest in great companies, we must first know what it takes to be great. Read Built to Last or Good to Great by Jim Collins. Read Common Stocks, Uncommon Profits by super-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 those problems are only temporary. Here are some recent examples of great companies selling at discount prices for a limited time:

33% off
During the second half of 2005, Dick's Sporting Goods decided to run a sale. Unfortunately, the discount wasn't just on merchandise. The price cuts started Aug. 16, 2005, when Dick's reported flat same-store sales for the quarter at its namesake stores, then revised its pro forma earnings estimate downward. That bad news was good for a 16% discount in one day. The market continued to sour as it digested the news, sending the stock below $27.

Dick's is a rapidly expanding retailer that experienced some problems with its Galyan's acquisition. Apparently, sales lagged projections. But that's one of the drawbacks of playing the expectations game: If you set them too high, then don't meet them, the market greets you with animosity.

But when a traditionally good operator stumbles, and the market overreacts, opportunity could be knocking. Investors looking beyond the setback found a good price for a growing retailer that produces good returns on invested capital.

80% off
The digital age had a huge effect on investing. We'll go over two companies that were on the cutting edge early on, when their prices rose quickly based on their great stories ... only to fall when the initial shine started to wear off. The first example is Investment Technology Group, which provides pre-trade, trade, and post-trade technologies and brokerage services to help clients manage risk, execute trades, and monitor and control costs to maximize returns.

Growing as markets became more digitized, Investment Technology Group capitalized on the early success of the revolution. But things cooled off as clients began trading less. In December 2002, the company announced that it would miss its quarterly earnings estimates, and so it lowered guidance (have you picked up on a recurring theme here?).

But a change in the environment does not negate good technologies or a good business. Investment Technology Group had both, and the market recognized that over time.

95% off
E*Trade's experience is similar. Sales and profits dried up as investors traded less when the bear assaulted the Street. Throw in stiff competition from Charles Schwab (NASDAQ:SCHW) and Ameritrade (now part of TD AMERITRADE (NASDAQ:AMTD)) along the way, and the sudden resignation of a greedy CEO, and it's easy to understand why investors fled to the exits.

But E*Trade had a strong following and excellent brand recognition, not to mention its refusal to hang its hat solely on brokerage services. It also offered online banking and mortgage services. So when the panic wore off, E*Trade and its new leadership were able to extract some nice profits from the valuable assets it had acquired, translating into some big gains for investors over the past few years.

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

Home Depot (NYSE:HD) has had plenty of ups and downs over the past few years. It spent lots of capital buying its Home Depot Supply business only to sell it down the road. It's had activists fight for shareholders' interests regarding former chairman and CEO Bob Nardelli's compensation package. And it's seeing growth slow even as critics question its commitment to customer service at its stores.

New leader Frank Blake has pledged to get the most out of its stores, and he's begun recapitalizing the company. Famed value investors such as Franklin Mutual Advisers and Richard Pzena have taken big stakes in the company. They must -- as we do at Inside Value -- continue to think the stock is cheap ... and smell opportunity.

On sale tomorrow ...
Who will be tomorrow's next big bargain? That's what Philip Durell and his Inside Value team are dedicated to finding out. If you'd like to take a look at the stocks we're recommending today, click here to join our community free for 30 days. There's no obligation to subscribe.

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

Retail editor and Inside Value team member David Meier does not own shares in any of the companies mentioned. Charles Schwab is a Motley Fool Stock Advisor selection. Home Depot is an Inside Value recommendation. The Motley Fool has a disclosure policy.