Just How Ugly Is This Stock?

How would you like to own the stock of a company that's losing money? In this era of tight credit, unforgiving debt covenants, and the potential for a government takeover if a company falters, it may seem insane to even consider such an "opportunity."

But first impressions can be wrong. Especially in this strained economy, it is quite possible for a fundamentally solid company to report losses that are truly transient and one-time. If market participants react unfavorably to the headline news of a strong company's loss, it creates an opportunity for you to pick up its shares on the cheap.

How can a strong company lose money?
In the short run, profit and loss accounting almost has less to do with how a company is truly operating than it does with how its management team thinks things are going. There are all sorts of levers that the executives can pull to either artificially increase or decrease reported earnings based on the specific story they want to tell.

For instance, there's a phenomenon known as "kitchen sink accounting," whereby a company that's about to report bad news will intentionally compound it with even more bad news. Among the loss-increasing moves a company can make without really affecting its cash position are:

• Aggressively test good will to increase the likelihood it will need to be impaired.
• Decrease the amount of its receivables it anticipates being able to collect.
• Reduce the expected returns on its pension assets.

These sorts of moves are often made either to hide a small operational shortcoming among the noise of the bigger losses or to set the company up for next year's easy year-over-year comparisons.

You can profit from the resulting confusion
If the market is in a "shoot first and ask questions later" state of mind, it may look at the headline losses and simply start one of its periodic and all-too-common bouts of panic. In those cases, a company's stock can tank as if it were on the verge of bankruptcy. That collapse will happen based almost entirely on the market's first impressions, regardless of the true cause of the bad news.

Yet in the end, if a company is fundamentally strong and the market's first impressions fundamentally wrong, recovery will occur. As an investor, you have a chance to profit from that recovery. But in order to do so, you need to own your shares before the recovery takes place. That requires you to learn to spot a strong company hiding behind its reported losses.

Identify hidden strength
While there are no guarantees in investing, you're most likely to find hidden strength among money-losing companies that are still fundamentally solid, despite their accounting losses. A company is more likely to be strong enough to thrive in the future if it:

• Maintains positive free cash flow, even as its reported earnings turn sour,
• Has positive equity on its balance sheet, even after posting its losses, and
• Is expected to soon return to profitability.

Companies like these, for instance:

Data from Capital IQ, a division of Standard and Poor's.
*Defined as cash from operations, less capital expenditures.

Their balance sheets are strong enough for them to continue working through the mess, and their positive cash flows help ensure they can pay their bills as they come due. When combined with the expectation that they'll soon return to profitability, you've improved your chances of finding fundamentally strong companies going through temporary rough patches. And as they recover, the shareholders who owned when things looked bleak will reap the benefits.

Own the diamonds in the rough
At Motley Fool Inside Value, we're always on the lookout for companies that are stronger than their market prices might indicate. As long as the market continues to have incorrect first impressions, there will be stocks available at bargain prices for us to find.

If you're ready to overlook short-term blemishes to own the strong companies behind some fairly weak stocks, then join us today. If you'd rather first see how you can benefit by pouncing on the market's misperceptions of companies' true values, your 30-day free trial starts by clicking here.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta did not own shares of any company mentioned in this article. The Fool has a disclosure policy.