12 Rules for Turnaround Investors

08/04/2011 8:30 am EST

Focus: STOCKS

George Putnam

Editor, The Turnaround Letter

In honor of the 25th anniversary of The Turnaround Letter, George Putnam III thought it might be a good time to look back at some of the important lessons he’s learned over the last quarter century.

None of these lessons represent the key to instant riches, but if kept in mind they should help you reduce mistakes and generate good profits over time when you invest in turnaround situations.

Turnarounds are still inefficient. One of the most important things we’ve learned is that the basic premise that drove us to start the newsletter is still true: turnarounds represent an inefficient niche in the market where you can earn abnormally high returns.

There are a number of reasons for this:

  • turnarounds can be hard to understand
  • investors are often biased against a turnaround name because of its troubled past
  • you usually can’t get much insight into future performance by looking at historical results

A low price doesn’t necessarily make a stock cheap. There may be good reasons why a stock trades at a low price.

Moreover, every stock that becomes worthless trades at a low price for a while on its way to zero. You have to find a reason why a stock’s price will increase—a catalyst of some sort.

Look for a solid core business. For a turnaround to succeed, the company must have a solid core business on which to rebuild.

A good brand can be a helpful part of that core business, but it is not enough by itself. There are numerous famous brands that have disappeared over the years. Just ask anyone who owns Blockbuster or Borders stock today.

If there is a problem with the core business, determine whether it is cyclical or secular. Some companies often run into trouble when the economy softens, but their core business remains viable, and they will rebound when conditions improve. The airlines fall into this category.

In other cases, there may be long-lasting changes in the way an industry does business that a particular company has missed. Here again, Blockbuster and Borders are good examples of companies that were left behind by secular changes.

NEXT: Always check the debt.

|pagebreak|

Always check the debt. Often it is a company’s heavy debt burden that gets it into trouble, and even if that is not the case, too much debt could still impede the turnaround.

For a successful turnaround, the company must either be able to service its debt or reduce it. If a company cannot service its debt, and looks as though it will be forced to restructure, perhaps in Chapter 11, you probably don’t want to buy the stock.

But you may want to consider buying the debt. Often, when a company restructures, the holders of the debt end up owning most of the equity in the reformed business.

Stocks of companies in bankruptcy are almost always worthless (or close to it). When we considered launching this newsletter, we thought we’d be focusing a lot on the stocks of companies in Chapter 11.

Then we did some research and discovered that stocks of bankrupt companies almost never do well. To come out of Chapter 11, a company must satisfy all of its other creditors before it can give stockholders anything.

And it is a very rare bankruptcy where there is any real value left for stockholders after all the other creditors have been paid off. Most of the value in the business (often represented by new stock) will go to holders of the company’s debt and other obligations.

However, the stocks of companies that have emerged from bankruptcy are often undervalued. When a company uses the bankruptcy process properly, it can emerge as a much stronger business, often with a very healthy balance sheet.

But most investors don’t realize this, and they think of the old, troubled company when they look at the stock. Therefore, these post-bankruptcy stocks are often over-looked and undervalued.

But not every post-bankruptcy stock does well. Over the years, we’ve learned about Chapter 22 and Chapter 33. (Unlike Chapter 11, you won’t find these chapters in the Bankruptcy Code—they are colloquial designations for companies that file for bankruptcy two or three times).

Sometimes, the company doesn’t reduce its debt enough while in Chapter 11, or perhaps the business just wasn’t viable for some other reason. The roster of Chapter 22s and 33s even includes some prominent names, such as Polaroid, TWA, Grand Union Supermarkets, and Levitz Furniture.

You should not try to time the market. While there may be cycles in the stock market—and there definitely are credit/bankruptcy cycles—we don’t know anyone who can successfully time those cycles.

Some people may get out of the market at a good time, but then they don’t get back in and miss a big upswing—or vice versa. We continue to advise always staying as fully invested as you can and still sleep at night.

Diversification is still essential. We were pretty sure about this when we started the newsletter 25 years ago, and we are even more certain of it today.

No matter how much research you do on a turnaround situation, sometimes it will not work out the way you expect. Turnarounds have a lot of moving parts, and it is hard to get all the parts right.

The best way to mitigate the risk of making a bad call is to diversify your holdings. That reduces the damage that a bad pick (or unforeseen event) can do to your portfolio.

Patience is also still essential. Many times, if you do your homework, you will ultimately be right about a turnaround, but the rebound will take longer than you expect.

Few things in investing are as frustrating as making a good call, but selling the stock just before it takes off because you have gotten tired of waiting.

Humility is key, too. When it turns out that you were not just early but were actually wrong about an investment, it is important to acknowledge your error, try to learn from it, and move on.

One of the reasons that turnaround investing remains an inefficient, and therefore profitable, niche is that many investors dabble in a turnaround situation or two, lose money on it, and say “this turnaround stuff is really risky and I’m going to try something more sensible like chasing hot growth stocks.” (Talk about a risky strategy!)

Subscribe to The Turnaround Letter here…

Related Reading:

Related Articles on STOCKS