Some investors and traders love turnaround stories. Today we are going to discuss what turnaround stocks are really and points to consider while investing in turnaround stocks.
Turnaround investing involves taking position or buying stocks of companies that have encountered severe financial and operational problems but are poised to rebound. Financial and operational problems decimate the company’s stock price and its business model; some time it’s so much so that company’s survival is questionable. Companies restructure themselves and investors make an entry when companies are about to turn around their business and financial position. Turnaround investing is also described as the contrarian play, since this involves betting on a company that most others don’t believe in.
Some example of turnaround companies are shown in below given picture:
Some things to keep in mind while evaluating a turnaround investing opportunities are:
- Industry/Sector-the Company should not be in dying industry or sector or else turnaround may not be permanent
- Leverage: Avoid companies with aggressive capital structure (for example: companies with more than 75% debt to capital ratio). Further, more corporate bonds are better than the bank loans.
- Debt Vs Cash: it is a happy situation if cash is more than the debt.
- Management: management team with turnaround experience is better than management with no turnaround experience.
- Business Model: the company should have sorted out apparent problem in its business model.
- Profitability: the company should be able to post sustained profit for at least couple of quarters after a long period of loss incurrence.
- Cash Flow: positive cash flow generation may signal good days for the company.
- Legal problem: if there were any legal issues, it should have been sorted out.
Investors should focus on the companies that emerge out of problems with relatively clean balance sheets, growing revenues and that are operating at a breakeven or better cash flow. Companies have to actually do more than just restructuring the balance sheet; they have to change management, restructure debt, fix the company operationally, reduce cost structures, develop new products and get them to market, settle lawsuits, fix bad acquisitions, etc. Many times it is very difficult to find information on these companies and hence a good research will certainly help. The truth is that the finding a good turnaround investing opportunities is beyond the skills, abilities, and education of a common investor. This is the reason most of the time it is a private equity or hedge fund game; these professionals have access to hard-to-get information on the internal performance of a company.
Investors should carefully evaluate turnaround opportunities in view of the above mentioned factors; otherwise, this type of investment may also lead to significant loss to investors. Actually, investing in a turnaround story is not for the faint-hearted. It has the potential to lead investors to a considerable loss. On the flip side, an investment in a turnaround story timed just right can yield significant return. For large and small investors alike, the risks are enormous, but the returns can be substantial too. It is a high risk- high return game at the end of the day.
To sum up, investing in turnaround stocks can be quite profitable if investors follow one simple rule: focus on companies that have identified the source of their problems and have delineated clear and workable solutions to stabilize and rebuild their business.