GREG HOFFMAN
February 24, 2010
In this fourth instalment of a five-part series, we'll examine turnarounds; a category beginner investors should be very careful of.
Like ice cream, turnarounds come in many varieties. The mildest form is the ''little-problem-we-didn't-anticipate'' kind of turnaround typified by Brambles' loss of 15 million pallets in Europe a few years ago.
Another is Aristocrat Leisure, which I recommended to The Intelligent Investor's members in June 2003 at $1.15 with the following quotes, fittingly, from Peter Lynch: ''Turnaround stocks make up lost ground very quickly'' and ''the occasional major success makes the turnaround business very exciting, and very rewarding overall.''
While I'm proud to have steered members into this great stock in its darkest days, I recommended people begin taking money off the table far too early in the turnaround process, beginning in March 2004 at $2.73 having recorded a gain of ''only'' 137%, when much more was to come. Thankfully we were recently given another bite at the cherry (as I explained in Betting on prosperous times).
Perfectly good company
Another category of turnaround is the perfectly-good-company-inside-a-troubled-one. I missed AMP in its ''lost years'', because I wasn't comfortable enough with the complexities of life insurance accounting to take the plunge. But Miller's Retail (now Specialty Fashion Group) provided an opportunity at its 2005 nadir, with progress in its women's apparel business being clouded by problems in its discount variety division.
Those brave enough to draw breath and buy the stock when I upgraded in May 2005 at 68.5 cents per share were rewarded with a 148% return in just 10 months before we sold in March 2006 at $1.70 (although the stock had provided a painful ride down prior to its relatively sudden resurrection).
Potential fatalities are probably the most uncomfortable type of turnaround. They can be explosive on both the up- and down-side.
My analysis of timber group Forest Enterprises on 8 March 2002 (Speculative Buy - $0.12) began: ''This company could go broke. But we're about to recommend you buy some shares in it.''
It may shock you that a conservative service like The Intelligent Investor could ever recommend a stock which has a significant chance of going to zero. But if the profit potential is large enough, and the percentage chance of it materialising is great enough, then we're prepared to risk a prudent percentage of our portfolios in a potential wipe-out situation.
Probability is the key
The key to turnarounds is to think about them in terms of probabilities. With Forest Enterprises back in March 2002, my probability calculation would have looked something like the accompanying table. (see below)
The stock ran even further after I recommended our members sell at 35 cents in April 2004, but that advice to sell quoted the words of famed American financier Bernard Baruch: ''Don't try to buy at the bottom and sell at the top. It can't be done except by liars.'' We were content with a near tripling of our initial outlay in just over two years.
The Intelligent Investor's sell-side record is a bit embarrassing on these turnarounds - tending to sell far too early. But buying is by far the riskiest part. Get one of these investments wrong and you could well be staring at a financial fatality - a ''bagel'', in the parlance of Wall Street.
Don't worry, though. You can live a rich and rewarding investing life without ever going near a turnaround situation in the sharemarket. You could also say the same about the final stock category we'll turn to on Friday: Asset plays. But asset plays appeal to a certain type of investor (I, for one, love 'em) and can offer great returns often with a good deal of underlying protection.
This article contains general investment advice only (under AFSL 282288).
Greg Hoffman is research director of The Intelligent Investor which provides independent advice to sharemarket investors.
http://www.businessday.com.au/business/markets/turnaround-stocks-the-pleasure-and-pain-20100224-p2pt.html
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