How can you tell the difference between out-of-favor stocks and stocks that are simply irredeemable? Here are a few key differences.
A great way to find turnaround candidates is to look for companies whose stocks have underperformed the broad market. These companies probably have something wrong with them, otherwise the market would be more supportive of their shares.
Selecting the right amount of underperformance is important. To find the most promising turnaround stocks, the underperformance needs to be deep enough to create a legitimate bargain but not so deep that the shares have become a lottery ticket – potentially a huge winner but with odds that are highly unfavorable.
Generally, the deeper the underperformance, the deeper the company’s fundamental problems. If the problems are deep enough – perhaps its products are not competitive, or the balance sheet is hopelessly over-burdened with debt – then the company isn’t just out of favor; it is probably out of time. In such cases, its shares are on track for a total loss.
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With the S&P 500 Index gaining 20% year-to-date, “deep underperformance” might mean stocks that have fallen by 40% or more over the same period. Currently, nearly 150 stocks (about 5% of our roster of domestic companies) fall into this ill-fated group. Over half of these laggards are in the healthcare sector, home to many lottery tickets.
2 Stocks that are Out of Time
One example is Amicus Therapeutics (FOLD), a biotech company whose shares have fallen 55% this year (and remain below their 2007 IPO price of 15) after a key drug test failed to show efficacy. Carrying $390 million in debt yet still hemorrhaging cash after decades of operations, Amicus has deep problems that indicate that its future is grim – and it is probably running out of time.
Shares of SmileDirectClub (SDC) have dropped 50% this year. These shares recently traded 74% below their IPO price of 23, as their business model of do-it-yourself orthodontics seems unlikely to succeed. The company’s revenue growth is stalling while its $726 million in debt is paired with large and chronic negative free cash flow. The share price spike in recent days appears to be driven by meme stock traders pressing against the large short interest, but this speculation only highlights the company’s low chances of a fundamental turnaround.
2 Potentially Out-of-Favor Stocks
HighPeak Energy (HPK) shares have fallen 41% this year, but look more appealing. This small-cap ($870 million market cap) company is the oil and gas exploration business, with several properties in Texas. While still high-risk, partly due to elevated drilling spending that exceeds its cash flow, the company has an improving production profile, and its oil-heavy production mix is benefitting from high commodity prices. HighPeak carries essentially no debt. At 4.9x EBITDAX, the valuation is unchallenging.
A company whose shares are stuck in the middle is Boston Beer (SAM). The shares are somewhat out of favor but the company is clearly not out of time. Boston Beer brilliantly captured the hard seltzer trend, which has driven its shares up more than 6x since year-end 2017. But the fad is fading, leading to two consecutive disappointing earnings reports and a stock price that has fallen 60% this year. Fundamentally, Boston Beer is in good shape – its revenue stream looks sturdy (albeit not growing so fast any more), it generates sizeable free cash flow, and has a debt-free balance sheet. The only problem is that the still-elevated valuation, at 18x EV/EBITDA, isn’t a bargain yet. But, at a lower price, perhaps in the 300 to 400/share range (it’s currently at 532), SAM shares would be appealing.
As specialists in turnaround investing, we focus on companies that have “the right stuff” but whose shares are currently out of favor for what we believe are temporary reasons. We often look for a catalyst that will reverse the company’s direction back toward prosperity.
In my Cabot Turnaround Letter, we use contrarian investment strategies and 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. To learn how to subscribe, click here.
Do you own any formerly out-of-favor stocks that have turned it around? Tell us about them in the comments below.
Bruce has more than 25 years of value investing experience, managing institutional portfolios, mutual funds, and private client accounts. He has led two successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company. Now he is helping his Cabot Undervalued Stocks Advisor readers find those undervalued stocks that let you buy low and sell high!Learn More >>