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:

  • Bail Us Out Or Else: whole deal depends on a government bailout.

  • Who Would’ve Thought: can lose money in utilities?

  • 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.

  • 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

  • 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 break- even 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.

CYCLICALS
Traits

• • Sales and profits rise and fall in regular, if not completely regular fashion, as business expands and contracts.

  • Timing is everything. Coming out of a recession into a vigorous economy, they lourish more than Stalwarts. In the opposite direction, they can lose >50% very quickly and may take years before another upswing.

  • Most misunderstood type, and investors can lose money in stocks considered safe. Large Cyclicals are falsely classified as Stalwarts.

  • If a defensive Stalwart loses 50% in a slump, then Cyclicals may lose 80%.

  • It’s much easier to predict upswing, vs, a downturn, so one has to detect early signs of business changes. You get a working edge if you’re in the same industry – to be used to your advantage. Most important in Cyclicals.

  • Unreliable dividend payers. If they’ve financial problems, then they become potential Turnaround candidates.

  • Inventory build-up = bad sign. Inventory growth > Sales growth = red flag. Inventory build-up with companies having fluctuating end product pricing causes larger problems.

  •  Monitor inventory to figure out business direction. If inventory is depleting in a depressed company, it’s the first evidence of a possible business turnaround.

  • High Operating Profit Margin (OPM) = Lowest Cost producer, who’s got a better chance of survival if business conditions deteriorate.

  •  Upswing favours companies with Low OPM’s. Therefore, what you want to do is to Hold relatively High OPM companies for long term and play relatively Low OPM companies for successful Turnarounds / cycle turns.

  • The best time to get involved with Cyclicals is when the economy is at its weakest, earnings are at their lowest, and public sentiment is at its bleakest. Even though Cyclicals have rebounded in the same way 8 times since WWII, buying them in the early stages of an economic recovery is never easy. Every recession brings out sceptics who doubt that we will ever come out of it, who predict a depression and the country going bankrupt. If there’s any time not to own Cyclicals, it’s in a depression. “This one is different,” is the doomsayer’s litany, and, in fact, every recession is different, but that doesn’t mean it’s going to ruin us.

  • Whenever there was a recession, Lynch paid attention to them. Since he always thought positively and assumed that the economy will improve, he was willing to invest in Cyclicals at their nadir. Just when it seems it can’t get any worse, things begin to get better. A comeback of depressed Cyclicals with strong balance sheets is inevitable. Cyclicals lead the market higher at the end of a recession – how frequently today’s mountains turn into tomorrow’s molehills, and, vice versa.

  • Cyclicals are like blackjack: stay in the game too long and it’s bound to take back all your profits. Things can go from good to worse very quickly and it’s important to get out at the right time.

  • As business goes from lousy to mediocre, investors in Cyclicals can make money; as it goes from mediocre to good, they can make money; from good to excellent, they may make a little more money, though not as much as before. It’s when business goes from excellent back to good that investors begin to lose; from good to mediocre, they lose more; and from mediocre to lousy, they’re back where they started.

  • So, you have to know where we are in the cycle. But it’s not quite as simple as it sounds. Investing in Cyclicals has become a game of anticipation, making it doubly hard to make money. Large institutions try to get a jump on competitors by buying Cyclicals before they’ve shown any signs of recovery. This can lead to false starts, when stock prices run up and then fall back with each contradictory statistic (we’re recovering, we’re not recovering) that is released.

  • The principal danger is that you buy too early, then get discouraged, and, sell. To succeed, you’ve to have some way of tracking the fundamentals of the industry and the company. It’s perilous to invest without the working knowledge of the industry and its rhythms.

  • Timing the cycle is only half the battle. Other half is picking companies that will gain Most from an upturn. If Industry pick = Right, but Company pick = Wrong, then you can lose money just as easily as if you were wrong about the industry.

  • If investing in a troubled industry, buy companies with staying power. Also, wait for signs of revival. Some troubled industries never came back.

  • If you sell at 2x, you won’t get 10x. If the original story is intact or improving, stick around to see what happens and you’ll be amazed at the results.

  • Examples
    Auto, airlines, steel, tyres, chemicals,
    aerospace & defence, non-ferrous metals, nursing, lodging, oil & gas   

FAST GROWERS

Traits

• Small, aggressive new companies. Growing at 20-25%.

• Land of the 10-40x, even 200x. 1-2 such companies can make a career. 

• Lousy Industry

  • May not belong to fast growing industry.

  • Can expand in the room in a slow growth industry by taking market share.

  • Depressed industries are likely places to find potential bargains. If business improves from lousy to mediocre, you are rewarded, rewarded again when mediocre turns to good, and good to excellent.

  •  Moderately fast growers (20-25%) in slow growth industries are ideal investments. Look for companies with niches that can capture market share without price competition. In business, competition is never as healthy as total domination. 

  • Growth ≠ Expansion, leading people to overlook great companies like Phillip Morris. Industry wide cigarette consumption may decline, but company can increase earnings by cost cuts and price increases. Earnings growth is the only growth that really counts. If costs rise 4%, but prices rise 6%, and profit margin is 10%, then extra 2% price rise = 20% increase in earnings.

  • Greatest companies in lousy industries share certain characteristics:
    i)  low cost operators / penny pinchers in the executive suite
    ii)  avoid leverage
    iii)  reject corporate hierarchies
    iv)  workers are well paid and have a stake in the company’s future
    v)  they find niches, parts of the market that bigger companies overlook. Zero Growth Industry = Zero Competition.

  • Hot Industry

    • Hot Stocks + Hot Industry = Greater Competition. Companies can thrive only due to niche/moat/patents etc.

    • Growth ≠ Expansion. In low growth industries, companies expand by capturing market share, cutting costs and raising prices. When an industry gets too popular, nobody makes money there anymore.

• Life Phases of a Fast Grower: each may last several years. Keep checking earnings, growth, stores to check aura of prosperity. Ask, what will keep earnings going?
  i)  Startup phase: companies work out kinks in the basic business. Riskiest phase for the investor because success is not yet established.
  ii)  Rapid Expansion: company enters new markets. Safest phase for investor where most amount of money is made, because growth is merely an act of duplication across markets. Company reinvests all FCF into expansion. No dividends help faster expansion. IPO helps in expanding without bank debt / leverage.
  iii)  Maturity / Saturation: company faces the fact that there’s no easy way to continue expansion. Most problematic phase because company runs into its own limitations. Other ways must be found to increase earnings, possibly only, via luring customers away from competitors. If M&A / diworseification follows, then you know management is confused.

• Examples

Annheuser Busch, Marriott, Taco Bell, Walmart, Gap, AMD, Texas Instruments, Holiday Inn, carpets, plastics, retail, calculators, disk drives, health maintenance, computers, restaurants