Investing In Turnaround Stocks

Turnaround stocks are stocks of companies that have gone through a phase of weak financial performance and whose share prices have been beaten down,but are likely to rise again as companies change their business strategy to become profitable again.

Now,if you are the bargain minded sort,you are bound to be attracted to this idea of identifying gems going cheap,holding them long,and having your wisdom and foresight validated by tidy profits …..!

But do contain your eagerness and look before you leap.Investing in turnaround stocks can yield spectacular returns to investors willing to buy into them when there literally seem be few takers and hold on,but then again wrong calls can lead to permanent loss of capital when the anticipated turnaround doesn’t  happen or gets stalled.

The most common mistake newbies make is in confusing turnaround investing with punting on the heroes of the past which have fallen into bad times,looking at historic price levels of these stocks and thinking that those will be realized some day in the future, and they will make money. However, this is the worst way to invest in turnaround stocks.And almost guaranteed to cost you your capital.The only way of not falling prey to falling for such stocks and such stupidity,is to stay away from religiously consuming stock news indiscriminately.

There are four categories of turnaround stock investments that are possible :

1. Growth Stocks That Have Fallen Into A Rough Patch:

Growth stocks with no balance sheet issues falling into a rough patch are the safest form of turnaround investing. The reason is that profits are under pressure, but as the balance sheet is safe, there is no danger of the business collapsing or the company going under. For example in 2014 Britannia Industries was going through a rough patch, with pressure on margins and increase in competitive intensity. Valuations had come down to multiyear levels. However, it was still a cash rich company. Turnaround was not imminent but was certain given the management focus and its products and brand. Over the next few years, margins bounced back, new categories did well for the company and the stock delivered 500% returns in a period of 5 years. The same was the case with Multiplex Companies in the year 2018 when the news of outside food being allowed into Cinema Halls came up. Stocks fell by 30-40% and that was the best time to invest. From there in a period of a few months stocks rallied by 60-70%. Personally,this is a category of stocks I like investing in,especially if they are products and services I use on a routine basis,as I get to routinely observe the customer facing aspects of the business and get to form an independent opinion of how well the anticipated turnaround is progressing.

2. Commodity Stocks At The Bottom Of The Cycle When turnaround Is Imminent:

Commodity stocks have cycles and the key to investing in them is to ride the cycles. Unlike normal growth stocks they cannot be held across periods of time. Typically, commodity stock prices follow the underlying commodity and are leveraged to them. So when the commodity moves up or down by let’s say 5%, the stocks will react by a multiple of that at 20-30%. The reason for this is that in the case of most commodity companies ,costs are more or less fixed or less variable and when the price of the commodity falls too much these companies go into losses and when the prices rise the profit increase is very huge. This is called operating leverage. Last year around this time everyone was very negative on the sugar sector, prices were down, companies were making losses, there were huge overdues to sugar farmers etc. However, government policies were turning favourable and the sugar prices had made a bottom and would only recover from there. As an added benefit there was the entire ethanol story. That was the time to buy into sugar stocks and from there many of them are up 100-200%. Most other commodity stocks like in Steel, Aluminium, Oil etc follow the same cycle.Now,if you work in the wholesale markets or otherwise have to track the prices of these commodities on a routine basis,perhaps because you have to buy them as imputs for your business,you’re in a very good position to be investing in such stocks.

3. Companies With Stretched Balance Sheets Which Could Turnaround :

This is the most speculative way of turnaround investing as here the balance sheets are bad and most of the equity value has eroded and because of that stock prices might be at multiyear lows. Most retail investors are attracted to these kinds so companies however this is dangerous as in many cases there is no equity value left or is difficult to evaluate as in the case of companies like JP Associates, Lanco, GMR, GVK etc. As such there needs to be proper evaluation done of these companies as to whether the turnaround is possible and even if it happens, whether it will actually add to the equity returns. Some infrastructure stocks, mid-caps that have done capital expenditure and capital good companies are in this category today. Personally,I prefer not to touch such such stocks with even a barge pole.There simply are many more easier and more predictable ways of making money.Why get emotionally attached to other people’s brands and babies?

4. Macro Factors Have Led To Poor Profits :

In these cases there is not much wrong that the company itself has done but there are macro factors which have led to the company not doing as well. This could be reduced profitability of exporters due to adverse currency movements or the target market not doing well. There could be a period of recession or slowdown across the board because of which all stocks fall. However, when the upswing plays out all that have fallen will not rise, only some with strong business fundamentals will rise. Many that did well in a big upswing might not rise again. These time periods typically are very good for investing in turnaround stories as all good and bad companies have fallen together and portfolios can be rejigged into potential future winners rather than those which will not recover.Personally,I’ll consider investing if the macro factors are of a more domestic nature,addressable by the GOI,on foreign governments,I’d prefer not to gamble too much. After all,their first priority can’t be saving Indian companies and their shareholders.