There are countless metrics and indicators that an investor can look at when considering buying a stock. Some use price-to-earnings (P/E) or price-to-book ratios. Others use EBITDA and balance sheet metrics. And many traders eschew fundamental analysis altogether and opt to use purely technical indicators like moving averages or relative strength.
As value-oriented investors, we seek to identify gaps between what a company is actually worth and how the market is currently valuing the company. Companies executing on a successful turnaround are some of the best candidates to successfully close that value-perception gap.
There is a combination of four traits in particular that I find to be the most effective for identifying these stocks. The combination of traits is critical; no single trait can isolate the conditions most likely to produce a worthwhile turnaround stock.
My four traits are: an out-of-favor stock, a catalyst, a sharp undervaluation compared to the post-turnaround scenario, and an attractive risk/return trade-off.
Let’s examine each of those four turnaround stock traits in greater detail.
Exploring the 4 Characteristics
What is an out-of-favor stock? To us, this means a stock that has produced a negative or marginally positive return over the past 3-10 years. Investors are actively bypassing these stocks, typically dismissed them out-of-hand. If you find yourself, upon seeing a company name, saying, “No, I wouldn’t touch that stock,” this is when we start getting interested. Such low expectations create opportunity – often it doesn’t take much good news to get this kind of stock moving up. Many of our best ideas come from stocks that have had among the worst performance in the stock market.
What is not an out-of-favor stock? One that has only recently produced lackluster returns. Disney (DIS) is an example. The shares are down 10% year-to-date in a strong market, and have dipped 21% from their highs. But the shares have produced gains in line with the S&P 500 over the past three and five years, and can’t be considered truly out-of-favor. Investors still love DIS, just perhaps not as much as before. PG&E (PCG) shares are out-of-favor.
The second trait is a strong catalyst. Out-of-favor stocks can remain that way for a long time, perhaps forever, as the management allows the company to lose its relevance and profitability. Without something to change the company’s fundamentals, its shares are true value traps. So, we look for a catalyst, a major change, including new leadership, the arrival of an activist investor, a spin-off or an exit from bankruptcy. These events can turn a struggling or merely uninspiring stock into a strong performer.
Not all catalysts are powerful enough to make a difference. Midwestern utility Ameren (AEE) replaced its CEO, but with a company veteran who appears to provide no change in direction. Or, perhaps the shares have already moved. Valvoline (VVV) recently decided to split its operations in two. This clearly is a major catalyst, but the shares, at close to 35, already price in most of the benefits. AT&T (T) is splitting itself into several pieces. This is a massive catalyst for a heavily out-of-favor stock. But it may not be enough, given the company’s difficult financial and strategic problems even after the break-up.
The third trait is attractive valuation. Even if a stock is out-of-favor and has a major catalyst, it needs the capacity to produce a worthwhile return. Our focus is not on current valuation, but valuation based on what the company will look like after its turnaround is complete. Not all turnarounds work as well as planned, and some fail. Our minimum return is 50% over 2-3 years, and many of our recommended stocks have produced much higher returns, including Albertsons (ABS), which gained 94% in 13 months, and Valero Energy (VLO), which produced a 93% gain in five months this past year.
Fourth, we want a favorable risk/return trade-off. Some companies have precarious financial positions; perhaps they have a highly-leveraged balance sheet or are generating large losses. These companies have sizeable bankruptcy risk, which would mean a 100% loss, and rarely (but not always) are worth making. PG&E (PCG), mentioned earlier, could slip into bankruptcy again if its wildfire risks or intense $20 billion capital spending plan produce large losses.
Do you have any turnaround stock success stories of your own? Tell us about them in the comments below!