Turnaround Investing: How to Pick Stocks
Looking to invest in turnaround companies? Knowing what to look for is critical in making sure you don’t end up losing all your money.
In this article I am going to share with you exactly what I look for when I am investing in turnaround businesses.
Let’s start by making sure we are on the same page as to what turnaround investing is.
What is Turnaround Investing?
Turnaround investing is when you invest in a company has encountered difficulties. They are attempting to get the business back to growth and sound financials.
The cause of the business issues can be from many causes. Including too much debt, industry struggles, or a miss guided strategy pivot.
This is not a startup, that is still trying to get to stability. But instead, a company that has already proven they can be successful. They once had stability and good financials, and something has gone wrong.
While investing in a turnaround can be a fantastic money maker, it is also very high risk. There are many things that must go right and managing that is difficult. Very few turn arounds are successful.
3 Ways To Find Stocks to Research
Before you can even decide if you want to invest in a turnaround company you need to find possible candidates! These are my three favorite ways to find stocks to research.
- Screeners – these are tools that allow you to input metrics that you want in a stock. It then narrows it down to only the stocks that meet those criteria. Most places that you have your investments will have one. I search for missed earnings and declining revenues.
- Transitional Industries – anytime you have an industry that is changing you will end up with winners and losers. It is a good place to look for companies that may have a chance of surviving.
- Read the News – anytime a company is struggling the news will write about it. Scan the headlines to see what companies might be facing problems.
What to Look For in a Turnaround
The following are the major areas that I look for in a turnaround. Every business and situation is different. So, you may find that you will need to add some categories during your research. Remember every investor is different, so my list might not include something you like to look for. Or something you don’t care about. Use the below and then adapt to your goals and personality!
Balance Sheet
When looking at the balance sheet, I am looking to make sure they can manage the turnaround without risk of bankruptcy. I look to see that current assets are able to cover not only current debts. But also, be able to finance any of the management strategy for achieving a turnaround.
Two metrics that I look at are: current ratio and debt to equity ratio. This is a quick way to do a preliminary check on the financial condition of the company.
The other thing that I take into consideration is the book value. If the company is trading close to book value. And the plan is good. And the book value is not all based on intellectual property or goodwill. Then investing may be a consideration, based on the business being able to be sold off. Or even being a takeover candidate.
Bankruptcy Considerations
In general, I avoid companies that are in bankruptcy or close to it. I do this for a couple reasons.
First, if the company goes into a liquidation bankruptcy the stockholders are last to get money. The first groups to get paid are vendors, employees, etc. Then bond and debt holders. Then finally at the very end the stockholders.
If a company is doing bad enough that bankruptcy is on the table, it means they don’t have the money to meet all their financial obligations. Which means stockholders won’t have anything left.
Second, even if the company is planning to do a bankruptcy where they reorganize the debt structure. The fact is that either the turnaround plan is not working, or they didn’t start a turnaround in time. There are too many unknowns to take that risk. I want to wait till they are a couple quarters out of bankruptcy before I would jump in. I want to see how they manage the turnaround plan with the reduced debt load.
Companies on the verge of bankruptcy increase your risk! Be careful.
Understand the Past
I want to know how the business ended up in the position they did. Was it bad management? An industry shift? A circumstance beyond their control?
Understanding what happened, will help you better make decisions on the next consideration – management’s turnaround plan. For example, if the plan is to increase advertising spending. But the issue is actually that the demographic of the industry changed. Making the advertising ineffective, then the plan won’t work!
Management’s Turnaround Plan
This is where you are going to want to spend most of your time. To decide if a company has a chance of making it through a turnaround. First you must make sure the plan makes sense! Here are a few things that I do/look at to make decisions around this.
- Earnings Calls – this is my favorite way to get information from the company. You are hearing the plans and how it is going directly from the upper management. It also gives you an opportunity to hear how they do with questions. What their use of language says, and how that is different from prepared remarks. Tone of voice and word choices often say more than the numbers.
- Interviews – I will also look for interviews with the CEO. This will do the same as an earnings call. But it will also allow you to see body language.
- Experience the Service/Product – I love to do store visits when I can. This is a great way to see if what they are doing is actually working. When you walk in is there anybody there? Are the shelves empty? How are the employees. Go experience the company as a perspective business owner. This is not an option for all businesses, but for those that it is an option, consider it a must do!
- Competitors – I want to know what the competitors are doing. I also want to know where the company that I am considering stands in the industry. Are they at the bottom and can only compete on price? Were they once a leader and let a new company take over? The more you understand about the competition, the more you can decide if the turnaround even has a chance!
- Industry – besides seeing how the business compares to its competitors you want to see how the industry as a whole is doing. Is it an industry that is in turmoil? Is it a shrinking industry because something else took over? You can have amazing management. And even a great plan. But if the industry is the problem, then it won’t work. Unless the plan faces that issue head on.
- Timeline – what is the management saying about the timeline? When will the turnaround be done? What are the milestones along the way? Find out what those are and then do a reality check. Are they reasonable? Can they really pay off the debt with the cash flow they estimate? Unrealistic timelines can increase costs, and bring in more issues.
When to Sell a Turnaround Investment
This will be different for every stock and every person. I have some stocks that I invested in as turn arounds and kept them. They fit my portfolio goals, so I never sold. Then there are some where it hit a price that I believed was a good exit point. So, I sold.
The important thing here is to understand your goals, strategies and investing rules. This will help guide your decision. Remember what is right for you is unique to you. Your circumstances, needs and likes are all different than anyone else’s.
Here are some questions you can ask yourself to help make the decision.
- Is the turnaround over? If it is, does the stock fit into another one of your strategies? If it does, does it meet the criteria that you use for that strategy?
- Does the company have a continued growth story that appeals to me? If yes, does it fit my investing rules?
- Is there a reason to sell? Has management missed its timeline? Is the turnaround not working? Do you think it will still achieve its targets?
How to Emotionally Handle the Investment
One of the harder parts of investing in turnarounds is after you make the investment. The risk level, and the ups and downs of the stock, can be unsettling. You must be okay with your investment losing money for years. AND still be able to sleep. Here are some things to keep in mind.
- Think Long Term – most turnarounds take time. Give it five to ten years.
- Reevaluate Often – there are a lot of moving pieces in any business. And in a turnaround, they can quickly change the story. You need to be willing to continue your research every time something new is released.
- Limit Exposure – never put more than 10% of your assets into one company. Especially a turnaround.
- Ignore the Haters – by their very nature, turnarounds are unpopular. There will be more naysayers than those who are optimistic. Be okay with having a contrary investment.
Learn About Business
Hands down, the best thing you can do to improve your chances of being a successful turnaround investor is to study business. The more you know about business, the more you will be able to decide if what management is saying makes sense. Buying a stock is buying a piece of the business. So, you want to think like a business owner.
No business experience? These are some books I recommend you get started with.
