Ugly Stocks, Great Opportunities

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.

Unfortunately, companies often get cheap for a reason: Something may be wrong with them.

The ugly
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, when most analysts thought Coke's growth prospects looked dim.

Since 1988, Buffett's investment in Coke has earned approximately 12% annualized returns -- plus dividends. That's market-beating -- and quite impressive.

Motley Fool Inside Value lead analyst Philip Durell has also earned impressive returns in Coke (42% since January 2005) because he recommended the company to subscribers for many of the same reasons Buffett bought in 1988: Analysts doubted the brand's power and growth prospects. Coke's situation was just ugly enough to get you a great price on a good company.

The same could also be said for the volatile commodities prices that dog BJ Services (NYSE:BJS), the asbestos liability issues and homebuilding slowdown that scare investors away from USG (NYSE:USG), the doubts about growth potential that have hurt Diageo (NYSE:DEO), the weakening dollar that's sunk Ambassadors Group (NASDAQ:EPAX), and the ongoing skepticism that Whole Foods (NASDAQ:WFMI) can effectively integrate its purchase of Wild Oats.

When ugly is too ugly
But it can get pretty ugly out there on the market. Master small-cap investor David Nierenberg has told Fool co-founder Tom Gardner that there are two clear signs 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 Doughnuts is one stock that Nierenberg was avoiding when Tom interviewed him in 2005. Although new management was trying to turn around the business, the company had not yet released any new, reliable 10-Ks or 10-Qs. (It finally did so in April 2006.) As Nierenberg wondered to Tom before those releases, "[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 those questions, it was impossible to determine in 2005 at what price Krispy Kreme was a value -- if any.

After its enormous write-offs and ongoing difficulties, Merrill Lynch (NYSE:MER) looks like a company with accounting issues that investors should be wary about trying to understand or trust. Though it looks cheap, it's certainly a candidate that may not be worth your interest.

The Foolish bottom line
When you're trolling for values in the market, you'll find some ugly situations. Without reliable management and financials, consider the situation too ugly for your dollars.

Separating the ugly from the too ugly can be tricky. If you'd like some help, 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 owns shares of Whole Foods. Coca-Cola and USG are Inside Value recommendations. Whole Foods is a Stock Advisor pick. Diageo is an Income Investor selection. Ambassadors Group is a Motley Fool Hidden Gems Pay Dirt selection. No Fool is too cool for disclosure.