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 (NYSE: KO) 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 14% annualized returns. That's market-beating -- and it's not as impressive as it once was, only because Coke has again declined in recent years, and because analysts doubt the brand's power and growth prospects.

Will Coke stay down for the count this time? Motley Fool Inside Value lead analyst Philip Durell doesn't think so. He recommended the company to subscribers in the January 2005 issue, for many of the same reasons Buffett bought in 1988. Coke's situation is just ugly enough to get you a great price on a good company.

The same could also be said for the public relations difficulties facing Wal-Mart (NYSE: WMT), or the energy price volatility that keeps causing drops in Chesapeake Energy (NYSE: CHK), Nabors Industries (NYSE: NBR), and Petrohawk (NYSE: HK).

Although Coke's stock isn't firing on all cylinders right now, it is starting to come around. There are no illegalities, and CEO Neville Isdell is focused on spurring future growth. The returns should be solid from here.

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 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.