There are hundreds of traits that investors can use when looking for attractive stocks. Commonly used traits include P/E multiples, revenue and earnings growth rates, and momentum metrics like 50-day moving averages and relative strength. Each of these has its merits, but to find high-potential turnaround stocks, I focus on four that are the most effective. Using all four together is critical, as no single trait can isolate the conditions most likely to produce a worthwhile turnaround stock.
These 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.
What is an out-of-favor stock? To us, this means a stock that has produced negative or marginally positive returns over the past 3-10 years. Investors are actively dismissing these stocks, often categorically. If, upon seeing a company name you find yourself saying, “No, I wouldn’t touch that stock,” this is when we start getting interested. 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 performances in the stock market.
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What is not an out-of-favor stock? One that has only recently produced lackluster returns. Goldman Sachs (GS) is an example. The shares are down 11% year to date in a strong market and have dipped 20% from their highs. But the share price has risen over 40% in the past five years, not too different from the overall market, and its performance is reasonably similar to its peers, so it can’t be considered truly out of favor. Investors still like Goldman Sachs shares, just not as much as before. In contrast, Goodyear Tire & Rubber (GT) 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 fundamental direction for the better, its stock becomes a value trap. So, we look for a catalyst, a major change that can restore prosperity to the company, including new leadership, the arrival of an activist investor, a spin-off transaction or an exit from bankruptcy. These events can turn a struggling company into a strong fundamental performer, driving its shares higher.
Not all catalysts are powerful enough to make a difference. Spice company McCormick & Co. (MKC) recently replaced its CEO with a company veteran who appears to provide no change in direction. Or, perhaps the shares have little upside potential. Borg Warner (BWA) recently spun off its gasoline engine operations as Phinia (PHIN) but is now left with a huge and risky bet on electric vehicles, while its former subsidiary is exposed to strong competition in a no-growth market.
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. Constellation Brands (STZ) recently gave activist investor Elliott Management two board seats – a seemingly major catalyst – but the shares have risen 1,200% in the past decade or so, trade at record-highs, and sport a non-bargain 23x earnings valuation even if some of the activist changes are made.
Fourth, we want a favorable risk/return trade-off. Some companies have precarious financial situations like an excessively leveraged balance sheet or are generating large losses. These companies have sizeable bankruptcy risk, which would mean a 100% loss. These risks are rarely worth taking. RiteAid (RAD) is one of the most out-of-favor stocks in the market, has a capable new CEO and offers immense potential for a turnaround. But, its exceptionally leveraged balance sheet and grim competitive position could readily drive it into bankruptcy.
Not all turnarounds work as well as planned, and some fail. Our minimum targeted return is 50% over 2-3 years. Several of our recommended stocks have produced much higher returns, including Marathon Oil (MRO) which gained 166% in 10 months.
By using this combination of four traits, the Cabot Turnaround Letter has generated strong returns for its subscribers. Our track record, independently compiled and reported by Mark Hulbert and Hulbert Ratings, has provided our subscribers with returns that are among the best in the industry: +29.9% rate of return over the past three years (compared to the 13.7% three-year rate of return for the S&P 500).
Currently, the Cabot Turnaround Letter has 37 Buy-rated turnaround stocks on its recommended list. Check out our advisories for more information about how our advisories can help you find attractive turnaround stocks.
As specialists in turnaround investing, we focus on companies that have “the right stuff.” We do all the extensive idea searching and analysis to help you benefit from out-of-favor stocks. Our capabilities save you time while boosting your chances of profitable investing.
Best regards,
Bruce Kaser
Chief Analyst
Cabot Turnaround Letter and Cabot Undervalued Stocks Advisory
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