Investing in turnaround stocks is most difficult but can also yield strong returns to investors who are willing to take the risk. The risk obviously being that the turnaround might not take place at all and could get stalled and in that case, there could be a risk of capital loss. Most people think of turnaround investing as punting on heroes of the past which have fallen into bad times and they look at historic price levels and think that those will come one day, and they will make money. However, this is the worst way to invest in turnaround stocks.
There are 3-4 categories of turnaround stock investments that can be done.
- Growth stocks that have fallen into a rough patch- Growth stocks with no balance sheet issues falling into a rough patch is 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. One of the best examples of this was the investment I made in Britannia Industries back in the year 2014. The company was going through 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%. A similar thing is visible in many Automobile companies today where these companies don’t have debt, sales have come down due to high interest rates, poor consumer sentiment and tight liquidity. Margins have also fallen due to input cost pressures. However, going forward most of these things could reverse and valuations today are the lowest in several years. The key is to pick out the right stocks. Indian Pharma companies at some stage would also come into this category of stocks as they have gone out of favour now and valuations are becoming cheap.
- Commodity stocks at the bottom of the cycle when turnaround is imminent. Commodity stocks have cycles and the key is to ride the cycles Like 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, what does leverage to them mean, leveraged means that when the commodity moves up or down by lets 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 that 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. I will explain this with an example. Last year around the same 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 my view was that the sugar prices had made a bottom and would only recover from there. As an added benefit there was the entire ethanol story. THAT’S the time that we bought 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.
- Companies with stretched balance sheets which could turnaround. This is the most difficult of turnaround investing as here the balance sheets are bad and most of the equity value has eroded because of that and 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. Typically, cyclical companies would be in this category of stocks. Interest rate cycles also impact such companies as their interest costs are low so when the cycle is turning towards lower rates many of them will see their equity values come back substantially.
- Macro factors have led to poor profits. In my category of turnaround stocks this would be the last category where 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.
I hope you found this useful. Contrarian investing is different from turnaround or value investing and plays more on the psychology of the consensus in the markets. I will talk on that at some future stage.