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What you need to know about turnaround stocks.
Buying turnaround stocks can be very risky. By their very nature, they’ve been underperforming somehow, and it could be that internal challenges or uncertain trading conditions prove insurmountable. Because of this, the potential to lose money from investing in them can be high. By the same token though, the potential rewards may be above average.
It's all about perfect timing, but even if you don’t get in right at the beginning of a turnaround, you can still profit from a rising company that looks like it could have long-term potential.
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For most of the last two years, it’s been the high-flying tech stocks that have garnered all the headlines. But the economy is strong, interest rates are falling, and the bull market is spreading to other areas of the market, like value and turnaround stocks.
Former Cabot CEO Tim Lutts’ three criteria for turnaround stocks are capable management, a good plan and a revival of revenue growth. But let’s dig a little deeper into using those criteria to find turnaround stocks.
Turnaround Stocks: What to Look For
Let’s begin with Management. In most cases, weak management is the key that drove the company into a crisis. In some cases, if management is up to the task, it can admit the error of its ways and set out to show investors, employees and customers that it can reverse strategies. But very often, a restructuring of the executive team (or even the Board of Directors) is required in order to restore investor confidence.
A Plan or Strategy must be defined and with an accompanying timeline. One of the key elements of a good plan is managing cash flows—keeping a sharp eye on revenues and expenses, and cutting out the fluff, which may mean dispensing with businesses that are not contributing enough to the bottom line. Generally, a new strategy will include ideas for additional revenue and profit opportunities—new products, services or markets.
In a few cases, the company’s problem may be due to its environment, where the “paint everything with the same brush” philosophy permeates. Case in point, after the tech wreck of 2000, investors shied away from technology stocks. And following the recession of 2008-2009, investors wouldn’t touch a financial company for years—even those that weren’t involved with the subprime mortgage markets. So when the environment changes, suddenly, companies that were distressed may soon find new footing as turnaround stocks, making them once more attractive to investors. This is often the case with large interest rate moves, which can have a dramatic effect on certain industries, like finance, real estate and cyclical businesses.
Low Price-Earnings Ratios are a good indicator of a cheap valuation, although, as I’ve said in previous articles, “sometimes a dog is just a dog.” But a low P/E is a place to start. It is simply the price of the stock divided by four quarters of earnings (usually the last four quarters, but different analysts and websites use different denominators, so make sure you are comparing apples to apples). Also, investors might want to look at a company’s price/book ratio, which is the price of the stock divided by the sum of its assets, minus intangibles such as goodwill, perceived brand value, etc.
Most turnaround stocks will be trading at low valuations because the market and investors have (hopefully, just temporarily) given up on them. In other words, very few investors are interested in the stock. However, you must also consider that the P/E or P/B may be low because a company has poor management and doesn’t have a clue about turning its fortunes around.
Spikes in revenues and/or earnings are good indications that a company’s turnaround may be working. Again, all the other elements must be in place, but if they are, and the company’s financials begin to perk up, that’s a good indication that a turnaround is underway.
Please realize that investing in possible turnaround stocks is speculative, so make sure your total investment represents just a small portion of your portfolio.
And if you need help coming up with ideas for turnaround stock candidates, I highly recommend subscribing to our Cabot Turnaround Letter, where my colleague Clif Droke highlights promising investment opportunities in stocks poised for a reversal.
Click here to learn more.
*This post is periodically updated to reflect market conditions.
To do so, they buy at lows and sell at highs, but the amount of time it takes for a stock’s price to appreciate may be more. Also, there may be times when the stock may go through bear runs.
This becomes even more challenging considering the changing dynamics of industry over a longer period of time. New players in a particular sector are constantly rising to shine. The trick is to identify which company has the highest potential.
One such strategy is to identify turnaround stocks. These are stocks of companies which have gone through a phase of weak financial performance and share prices have been beaten down. The idea is to find companies that are likely to identify issues that lead to a weak performance and change their business strategy to become profitable again.
Here are some of the characteristics of turnaround stocks:
The potential of a stock to outperform is always dependent on the ability of the company to post profits. As a result, one of the key characteristics of such a stock is that the company admits its error and is willing to make changes. Invariably, this involves management restructuring. This is because it is easy for a new executive to accept the flaws of past strategies.
There could be changes in the external environment that is now more conducive for companies in one particular sector to grow. For example, the falling rupee hurt companies that depended heavily on imports. With a stable rupee, these companies would get into a phase of managing their costs better than before. High inflation also affects input costs. It would be a good idea to identify companies that reported a loss due to rising input costs and rupee fall. Companies talk about factors that affect their performance each quarter in their financial statements. They also outline strategies to work their way to profitability in these statements.
The new management then identifies the company’s problems and comes up with a well-defined business strategy over a particular timeline. One of the key aims of this strategy is to manage cash flows – the net of operating expenses and revenues – by cutting costs and selling assets not important for the core business like properties or units. This is also followed by an increase in sales push to drive revenues at the promise of incentives. These cash inflows could then be reinvested in the company to meet costs.
Turnaround stocks often have cheap valuations – that is low PE or Price-to-Earnings and PB or Price-to-Book value ratios. The PE ratio is a measure of how much investors shell out for each rupee earned, while the PB ratio is the amount investors are paying for each rupee of the company’s assets excluding the brand value and goodwill. This is because the company, and therefore the stock, is undervalued by the market. However, sometimes, PE ratios can be high if the earnings are very poor, and PB ratios can be negative if the companies’ liabilities or debt exceed its assets.
From Wikipedia, the free encyclopedia
A turnaround stock is a stock of a company that has hit some trouble and very well might get things better. This makes the stock go up quite a bit.
It’s a positive reversal in the performance of a company’s stock. There are three main reasons why a company might turn its fortunes around – a spike in sales, cost-cutting measures and the launch of an exciting new product.
Where have you heard about turnaround stocks?
It’s hard to believe it now, but Apple’s stock was struggling following the tech bubble burst and strong competition from the likes of Microsoft. But the launch of a new product in 2001 – the iPod (you may have heard of it!) – transformed its outlook, and it hasn’t looked back since.
