SPECIAL SITUATIONS ARE

a hallmark of Common Sense investing identifying stocks that, for one reason or another, are poised to defy market expectations and outperform market averages. It only takes a few successful special situations to turbo-charge your results, and beat broad market averages. They're a major reason I believe most investors can do better than an index fund.

Throughout the year I try to identify these opportunities. Still, it's one thing to recognize such a special situation; it's another to act on it, and then to recognize when it's over. Inevitably, some end in failure, at least from an investing standpoint. So it's always a pleasure to be able to announce that a special situation has reached a successful resolution.

On May 23, I identified Flir Systems, a maker of heat-sensing and night-vision surveillance cameras, as a special situation. Flir achieved special-situation status, as many candidates do, after investors punished it ruthlessly for missing earnings estimates for the quarter ended April 17. The stock plunged close to 20% that day and by mid-July was down to $21.64.

If you're not a regular reader of this column, chances are you've never heard of Flir. But the lessons of Flir can be applied to any special situation. I'd never heard of Flir until it showed up on a stock screen I ran. I subsequently recommended it back in April 2002 as one of the "Ten Stocks for the Next Ten Years." I bought all 10 of those stocks. I've always liked Flir's blend of high technology and defense contracting, especially after the renewed emphasis on security that followed the Sept. 11 terrorist attacks. The Department of Homeland Security has been a big customer for Flir, and the recent controversy over securing America's borders should also spur demand for Flir's night-vision equipment. I've also liked Flir's double-digit revenue growth, high margins and low debt.

With a market capitalization of just over $2 billion, Flir also qualifies as a small-company stock. Flir's profit shortfall didn't make headlines and barely got covered in the financial press, let alone mainstream publications. Investors often ask me how they can invest in little-known small- and midcap stocks when there are thousands to choose from, most unfamiliar. The answer is that you don't have to be a Jim Cramer, whose "Lightning Round" segments on "Mad Money" showcase his omnivorous mind for stocks. You can't invest in all of them anyway, nor do you need to be familiar with them. I only follow Flir because I discovered it on a SmartMoney screen and continue to own it. In my view, all investors should have a Flir or two in their portfolios. Although it has a respectable following among analysts, I like the idea that it's still relatively obscure.

After Flir's sudden fall in April, I read the transcript of management's analysis of the earnings. The company reiterated its full-year guidance and attributed the shortfall to a delay in one major government contract. When analyzing potential special situations, I always start with the premise that the market is right. But this explanation was so straightforward, and didn't strike me as any cause for longer-term concern, let alone a reason to slice 18% off the stock price. Curiously, almost the same thing happened to Flir in 2005. The company's assessment then proved accurate and the stock more than regained its lost ground. So I bought long-term calls and proclaimed Flir to be a special situation.

The good news came last week, when Flir reported a better-than-expected 29% gain in earnings on an 18% rise in revenue. By contrast to last spring, all the news was good: Flir announced an increase in its order backlog and raised full-year earnings and revenue targets. By this week the stock was at a 52-week high of nearly $32 a share.

I still like Flir longer term. Among other possibilities, its relatively small size and niche expertise would seem to make it an ideal acquisition target. Even so, I believe it's time to take some of those special-situation profits off the table. I can still maintain my exposure by cashing in my calls, which are now deep in the money, and buying some cheaper calls with a strike price closer to Flir's current price. In just five months, my Flir position has generated a return of more than 50%.

That leaves just one of my special situations unresolved: Time Warner. After I all but gave up on its stock, it has recently shown remarkable signs of life (along with other cable companies I recommended. My January 2007 calls with a strike price of $20 now look like they may finish in the money. Stay tuned.