Turnarounds

TURNAROUNDS

Traits
• No growth, potential fatalities – a poorly
managed company is a candidate for trouble
• Make up lost ground very quickly and
performance isn’t related to market moves
• Can’t compile a list of failed Turnarounds,
since their records get deleted after collapse
• Turnaround types:
i) Bail Us Out Or Else: whole deal depends
on a government bailout.
ii) Who Would’ve Thought: can lose money
in utilities?
iii) Unanticipated Problem: minor tragedy
perceived to be worse, leading to major
opportunity. Be patient. Keep up with
news. Read it with dispassion. Stay away
from tragedies where the outcome is
immeasurable.
iv) Good Company Inside a Bad one:
possible bankruptcy spinoff. Look for
institutional selling and insider buying.
Did the parent strengthen the company’s
balance sheet pre-spinoff?
v) Restructuring: company diworseified
earlier, now the loss making business is
being sold off, costs cut etc.
• How will earnings change?
i) Lower costs
ii) Higher prices
iii) Expansion into new markets
iv) Higher volume sold in old markets
v) Changes in loss making operations
• Buy companies with superior financial
condition. Young company + Heavy Debt =
Higher Risk. Determine extent of leverage
and what kind is it? Long term funded debt
is preferable to Short/Medium term callable
bank debt, which may trigger bankruptcy.
• Inventory growth > Sales growth = Red flag,
& inventory growth is a bad sign. Depleting
inventory means things maybe turning
positive. High inventory build up overstates
earnings - may mean that management is
deferring losses by not marking down the
unsold items & getting rid of them quickly.
• Asset/inventory values maybe inflated. Raw
materials are liquidated better than finished
goods. Check for pension liabilities and
capitalized interest expense in asset values.
• Upswing favours Turnarounds > Normal
companies. So look for low margin
companies to succeed via operating leverage
/ high cost of production.
• If the industry is robust in general and the
company’s business doesn’t do well, then
one maybe pessimistic about its future.
• If the entire industry is in a slump & due for
a rebound, & the company has strengthened
its balance sheet and is close to the breakeven 
point, then it has the potential to do
jumbo sales when the industry picks up.
• Name changes may happen due to M&A or
some fiasco that they hope will be forgotten.
• Are Turnarounds obvious winners? In
hindsight, yes, but a company doesn’t tell
you to buy it. There’s always something to
worry about. There are always respected
investors who say that you’re wrong. You’ve
to know the story better than they do and
have faith in what you know.
• For a stock to do better than expected, it has
to be widely underestimated. Otherwise, it’d
sell for a higher price to begin with. When
the prevailing opinion is more negative than
yours, you’ve to constantly check & re-check
the facts, to assure yourself that you’re not
being foolishly optimistic. The story keeps
changing for better or worse, and you’ve to
follow these changes and act accordingly.
• With Turnarounds, Wall Street will ignore
changes. The Old company had made such a
powerful impression that people can’t see
the New one. Even if you don’t see it right
away, you can still profit more than enough.
• Cyclicals with serious financial problems
collapse into Turnarounds. Also, fast
growers that diworseify & fall out of favour.
• If Slow Grower = Turnaround, then it’s
performance maybe > Stalwart/Fast Grower
• Remind yourself of the Even Bigger Picture –
that stocks in good companies are worth
owning. What’s the worst that can happen?
Recession turns into depression? Then
interest rates will fall, competitors will falter
etc. if things go right, how much can I earn?
What’s the reward side of the equation? Take
the industry which is surrounded by the
most doom and gloom. If the fundamentals
are positive, you’ll find some big winners.

Examples
• Auto (Ford Chrysler), paper, airlines
(Lockheed), steel, electronics, non-ferrous
metals, real estate, oil & gas, retail, Penn
Central, General Utilities, Con Edison, Toys
R Us spinoff, Union Carbide, Goodyear.
• Record with troubled utilities is better than
troubled companies in general, because of
regulations. A utility may cancel dividends /
declare bankruptcy, but if people depend on
it, a way must be found to let it continue
functioning. Regulation determines prices,
profits, passing on costs to customers. Since
the government has a vested interest in its
survival, the odds are overwhelming that it
will be allowed to overcome its problems.
• Troubled Utility Cycle:
i) Disaster Strikes: some huge cost (fuel)
can’t be passed along, or, because a huge
asset is mothballed & removed from the
base rate. Stock drops 40-80% in 1-2
years, horrifying people who view utilities
as safe & stable investments. Soon, it
starts trading at 20-30% P/B. Wall Street
is worried about fatal damage – how long
it takes to reverse this impression varies.
30% P/B implies bankruptcy, emergence
from which may take upto 4 years.
ii) Crisis Management: utility attempts to
respond by cutting costs and capex.
Dividend maybe decreased / eliminated.
Begins to look as if the company will
survive, but price doesn’t reflect the
improved prospects.
iii) Financial Stabilization: cost cuts have
succeeded, allowing it to operate on
current revenues. Capital markets maybe
unwilling to lend money for new projects
& it’s still not earning money for owners,
but survival isn’t in doubt. Prices recover
to 60-70% P/B, 2x from stage (i), (ii)
iv) Recovery At Last: once again capable of
earning and Wall Street has reason to
expect improved earnings and the
reinstatement of dividends. P/B = 1x.
How things progress from here depends
on, (a) reception from capital markets,
because without capital, a utility cannot
increase its base rates, and, (b) support
from regulators’, ie, how many costs are
allowed to be passed on?
• One person’s distress is another man’s
opportunity. You don’t need to rush into
troubled utilities to make large profits. Can
wait until the crisis has abated, doomsayers
are proven wrong, and, still make 2-4x in
short term. Buy on the omission of dividend
& wait for the good news. Or buy when the
first good news has arrived in stage (ii).
• The problem that some people have is they
think they’ve missed it if the stock falls to
$4, then rebounds to $8. A troubled
company has a long way to go and you’ve to
forget that you’ve missed the bottom.

People Examples
• Guttersnipes, drifters, down and outers,
bankrupts, unemployed – if there’s energy
and enterprise left.

2 Minute Drill
• Has the company gone about improving its
fortunes and is the plan working?
• General Mills has made great progress on
diworseification. Cut down from 11 to 2
businesses that are key and the company
does best. Others were sold at good price
and the cash was used for buybacks. 1 key
business’ market share has improved from 7
to 25% and is coming up with new products.
Earnings are up sharply.

Checklist
• Plan – how will it turnaround? Sell loss
making subsidiaries? Cut costs? What’s the
impact of these actions? Is business coming
back? New products?
• Survival – can it survive a raid by short term
creditors? Check cash/debt position, capital
structure, can it sustain more losses?
• Bottom Fishing – if it’s bankrupt already,
then what’s left for owners?

Portfolio Allocation %
• 20-50% Allocation, based on where greater
value exists - Turnarounds or Fast Growers

Risk/Reward
• High Risk – High Gain.
• Higher potential upside (10x) vs higher
potential downside (100% loss).

Sell When
• After Turnaround is complete, trouble is
over, everyone is aware of changed situation,
& the company is re-classified as a Cyclical/
Fast/Slow Grower etc. Stockholders aren’t
embarrassed to own the shares anymore.
• Stock is judged to be a 2x, but not 5-10x
• PE is inflated vs Earnings prospects, sell and
rotate into juicier Turnaround opportunities,
where Fundamentals are better than Price.
• Debt, which has declined for 5 consecutive
quarters, rises again. Indicates increased
chances of relapse.
• Inventory rise > 2x Sales increase.
• >50% sales of the company’s strongest
division’ come from some customer whose
sales are slowing down.

The Peter Lynch Playbook

Twitter@mjbaldbard 5 mayur.jain1@gmail.com