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.
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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.
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*This post is periodically updated to reflect market conditions.
