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.
One of Buffett's best investments was taking a major stake in Coca-Cola
Since 1988, Buffett's investment in Coke has earned better than 12% annualized returns -- plus dividends. That's market-beating -- and quite impressive.
It seems that today's market doubts the growth prospects for most companies. Such pessimism means that this is either the "end of days" or a promising long-term buying opportunity.
For example, credit-crunch/subprime/global-financial-crisis fears have waylaid retail-banking behemoth Bank of America
When ugly is too ugly
That's not to say everything is looking pretty out there. Master small-cap investor David Nierenberg has told Fool co-founder Tom Gardner that there are two clear indications that can help you steer clear 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 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 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.
Fool's final word
When you're trolling for values in the market, you'll find some ugly situations. Without reliable management and financials, you should consider the situation too ugly for your dollars. In today's environment, it's worth assuming that with a financial stock like Bank of America, additional write-offs are forthcoming ... if only to be conservative.
Separating the ugly from the too ugly can be tricky. If you'd like some help, consider a 30-day free trial of Motley Fool Inside Value. Our team 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.