We Buy Ugly Stocks

You know those signs on the highway, "We buy ugly houses"? The signposting buyers know they can turn something ugly today into beautiful profits tomorrow, all while paying the low, low ugly house price today.

I like to buy ugly stocks. Not death rattle stocks, but the kind of cheap, ugly stocks that will blossom into a lovely, overpriced McMansion I can sell for a whole lot more.

What are ugly stocks? I'm so glad you asked.

Turnarounds that turn around
Investors fear turnarounds for the right reason: They seldom turn around, so the stock is usually cheap.

But what if the possibility of a successful turnaround -- and the sweet rewards therefrom -- is greater than the risks of things getting worse? If management has a track record of successful turnarounds, the company's financials allow for some time to succeed, and the valuation is cheap enough, that possibility just might be worth banking on.

One example is Steak n Shake (NYSE: SNS) before late 2008. People consigned this once-great brand to the dust heap, driving shares down as if it would never sell another Steakburger or hand-dipped milkshake. Ugly stock? This was the poster child.

But a lot of us had seen the new CEO turn around two casual restaurant chains -- Friendly's and Western Sizzlin -- already, and the balance sheet gave him some time to succeed. It wasn't guaranteed; if it had been, we wouldn't have gotten shares cheaply. But when he and his team worked magic in only two quarters, I more than doubled my investment.

Today, the turnaround risk is gone, so you'd think the stock would be fully valued -- but you'd be wrong. The enterprise value to sustainable free cash flow multiple is still around 10. Cheap, and no more turnaround risk!

For those of you with elephant memories, I picked death-care provider Alderwoods when dinosaurs roamed the earth. It was out of bankruptcy, and the chairman and CEO were an established turnaround team with many successes behind them, yet investors shunned this ugly company in a boring, unattractive business.

I and other Foolish investors get on the improving balance sheet and master cash handlers at the helm. After the stock more than doubled, industry behemoth Service Corp. (NYSE: SVC) bought Alderwoods for a nice premium.  

Debt-laden down, but not out
Investors rightly fear debt-laden companies. Too many liabilities and no cash to pay them equal bankruptcy, and in the last two years, we've seen that banks do not always throw good money after bad. Investors desert companies with scary debt, making shares cheap.

But what if the company avoided bankruptcy, the creditors all extended a lifeline, and the restrictions are so great that current management is practically prohibited from doing anything other than improving the cash-debt equation? Then cheap is good.

That's the case with cement giant CEMEX (NYSE: CX) after last year's restructuring. Creditors have tightened the noose -- no dividends, buybacks, growth capital expenditures, or acquisitions, let alone jets or expensive parties. It has no choice but to pay down debt.

At today's prices, it's an excellent ugly house -- and we can snare the benefits of the renovation for cheap.

Too complex, but not really
Investors correctly worry that a business with too many moving parts is hard to value and that any of those parts could malfunction. Sometimes complex sells for less.

But if we know and can trust the boss 100%, we can hand the complexity risk over and sleep at night.

Do you have to understand every single part of conglomerate Berkshire Hathaway (NYSE: BRK-B)? Or its Canadian cousins, Brookfield Asset Management (NYSE: BAM) and Fairfax Financial Holdings? Not if you determine that these are run by tip-top capital allocators, people who spend your money for higher return year after year. You can hand over complexity risk to them confidently.

Plus, with Brookfield, you can get the same management via majority-owned and managed Brookfield Infrastructure Partners (NYSE: BIP) and gain the benefits of Brookfield Asset Management's master investor J. Bruce Flatt and his team but off a smaller company base. Investors fear the smaller company's structure, yet it pays a great dividend based on stable and high-quality cash-producing assets.

Yes, everyone knows Buffett and Berkshire, and it's true that no one would call them ugly. But you'd be amazed at how many investors fear the complex company (and don't let them fool you -- Berkshire is complex) and thereby miss Flatt at Brookfield or Prem Watsa at Fairfax. There are many more, too.

Ugly stocks are beautiful
I love buying ugly stocks, because they're where I can find higher future profits at lower cost and risk.

That's what we're doing at Motley Fool Special Opportunities, and I invite you to join me and my team as we search out ugly stocks that will make beautiful portfolios. But don't delay, because we're limiting the membership to make sure we can buy all the out-of-the-way stocks we can find, no matter the size. If you're interested, just put your email address in the box below.