IDENTIFYING TURNAROUND STOCKS

The Turnaround Letter

an e-report

IDENTIFYING

TURNAROUND

STOCKS

BY GEORGE PUTNAM, III

TIPS YOU CAN USE TO IDENTIFY

TURNAROUND STOCKS

THAT ARE READY TO MOVE

TABLE OF CONTENTS

Introduction 1

10 Ways to Spot Turnaround Opportunities 3

Two Other Keys to Successful Turnaround Investing 13

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2

ONE

INTRODUCTION

T

urnaround investing can be very profitable, but it is not without pitfalls. Year in and year out many of the biggest winners on Wall Street are troubled companies that turn themselves around and return to favor with investors. But, obviously, not every troubled company is going to turn into a success story. Some of them liquidate and others languish with depressed stock prices for years. Therefore, the key to turnaround profits is separating those companies that will recover and return to favor from those that won’t.

There are many reasons for the tremendous profit potential in turnaround situations, but most of them relate to the basic fact that most investors, including many “sophisticated” institutions, are afraid of turnaround situations. This means that they sell potential turnaround stock too soon – as soon as the company’s troubles become known – and they buy them back too late – only after they are certain that the company will recover fully. When these investors bail out that is usually the time to buy in!

However, you must choose your potential turnarounds carefully. A substantial number of troubled companies never do recover. Some studies estimate that as few as two percent of all bankrupt companies successfully reorganize. But these studies include all companies – from corner grocery stores to the biggest New York Stock Exchange companies. The odds improve greatly when

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you look at publicly traded stocks and bonds and ignore the small private companies that make up the vast majority of bankruptcies. My research shows that roughly one-third to one-half of all publicly traded companies that enter Chapter 11 bankruptcy proceedings are successfully reorganized. You can further improve your chances of spotting a successful turnaround by following the ten simple rules described in the next chapter.

TWO

10 WAYS TO SPOT

TURNAROUND

OPPORTUNITIES

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et forth below are 10 ways to evaluate potential turnaround investments. While it is unlikely that any investment opportunity will have all of the desirable characteristics mentioned, they should provide a useful framework for comparing potential investments.

LOOK FOR SOLID CORE BUSINESSES

In order to survive, a turnaround candidate must have a solid core business that will provide both immediate cash flow and opportunity for future growth. The company’s chances for survival may be further enhanced if it has some ancillary businesses that can be sold off to raise cash.

Frequently, a company that has several lines of business, at least one of which is in decent shape, has a much better chance of survival than a single-business company. The multiple-business company can sell off or close losing divisions and concentrate on its main money-makers. This may be enough to bring the company back to health. Companies often are in trouble because they expanded too quickly or entered new businesses that they did not understand, and so retrenchment is the solution.

10 WAYS TO SPOT TURNAROUND OPPORTUNITIES 4

The core businesses on which a company bases its survival need not be its biggest or best known line of business.

LOOK FOR WELL-KNOWN PRODUCTS OR BRANDS

A well-known product or brand can be very valuable to a company trying to recover from financial difficulties. It is essential for a turnaround company to maintain a certain level of sales to provide cash flow. This can be difficult when the company’s problems become public knowledge, particularly where servicing or some other form of post-sale contact with the company is important. Most people are reluctant to buy from a company that may shortly disappear. However, a well known product or brand may help to reassure customers and distributors.

The strong product or brand can serve different roles in a reorganization. It can serve as the core business on which the company’s survival is built, or it can be sold to raise cash to support some other core business. A well established product or trademark can be very valuable asset and can be sold off for much needed cash to assist in the reorganization effort.

COMPARE CASH FLOW TO OBLIGATIONS

A company needs a source of cash flow if it is going to survive. While it can forestall it creditors for a time by entering bankruptcy, it must eventually demonstrate that it is going to generate sufficient cash to pay off its obligations. More than that, to be of interest to investors, a company must be able to generate enough cash, after paying off its creditors, to provide either the growth or the dividends that will reward its stockholders.

Generally, a troubled company’s obligations exceed its cash flow. Therefore, it must either expand its cash flow or reduce its obligations or, ideally, both. It may just be a matter of waiting for recovery from a temporary dip in sales, but more likely some restructuring will be necessary. Perhaps assets can be sold and the proceeds used to reduce debt; cash draining operations can be closed; or overhead can be cut. The turnaround investor must analyze the company’s

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financial statements to determine where obligations can be reduced, assets sold and debts paid off without crippling the company’s business.

LOOK FOR MANAGEMENT CHANGES

Just as real estate experts say there are three keys to success in real estate – location, location, location – many turnaround experts feel that there are three keys to success in turnarounds – management, management, management. It is often management mistakes that lead a company into trouble in the first place, and management skill will be needed to extricate the company.

Frequently, a change in management is a good sign. If management does not have the skill to keep a company out of trouble, it is not likely to have the even greater skill necessary to get the company back on it feet. Turnaround management requires special skills, and it may be necessary to bring in turnaround specialists to save the company.

The announcement of the hiring of a turnaround guru is not, however, a sign that investors should immediately buy the company’s stock. Even the best turnaround managers may take a long time to revive a company, and there may be more bad news still to come.

Thus, a change in management may be a good sign, but it doe not make a company an immediate ‘buy”. Rather it means that the company’s chances may be improved somewhat and investors should watch it for other favorable signs in the future.

LOOK AT WHO OWNS THE COMPANY’S STOCK

Stock ownership can provide a number of important clues in turnaround situations. First, stock ownership by management gives them an extra incentive to get the company out of trouble. Second, where there is a major holder of the company’s stock, that person may take an active role in negotiations with creditors and will look out for the interests of other stockholders as he looks out for his own. Finally, the purchase of stock by

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an insider may be a clue that the company is about to show signs of recovery. When a company gets into trouble, a manager who is just a hired-hand is likely to quit and look for some other, more secure place to collect his or her paycheck. But a manager who owns a significant amount of stock is likely to try all the harder to turn the company around and give the stockholders more value. Often, turnaround specialists will be compensated partly with stock or options, and this can be a good sign for the stockholders. In these instances, the management knows it can maximize its own rewards by creating value for the other shareholders.

The presence of a major stockholder can be important to other stockholders. In both bankruptcy and near-bankruptcy situations, the creditors will play a major role in the restructuring of the company. If the company’s stock is widely dispersed, there may be no one to look out for the stockholder’s interests, and so the reorganization will be shaped solely by management and creditors, with the result that shareholders find their holdings substantially diluted. But if there are one or more major stockholders, they are likely to take an active role in the reshaping of the company. And as they look out for their own interests, these big holders are also protecting the interests of their fellow shareholders who may own only a few shares.

Just as with the arrival of a turnaround specialist, however, the purchase of a big block of stock by a major investor is not necessarily cause for immediate rejoicing by other stockholders. This is particularly true when the company is not yet in bankruptcy. There have been a number of cases where a big investor bought into a potential turn-around situation only to find that things were really a lot worse than he or she had been led to believe. This usually leads to lawsuits as the investor tries to rescind the deal, and the company’s problems are only increased.

Many investors are probably familiar with the investment technique know as “insider” stock trading. Corporate officers, directors and major stockholders are required to report their purchases and sales of stock to the Securities and Exchange Commission every month. These insider trades can give a clue as to how those with the best chance to know about a company think it will do in the future. This same reasoning applies to turnaround situations, and the technique can be especially valuable there. Long before anything really

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newsworthy happens, or before an upturn appears in a company’s financials, an insider may be able to see positive changes occurring and will purchase the company’s stock. This may be a sign that “outsiders” should consider buying it too.

WATCH FOR COMPANIES EMERGING OUT OF BANKRUPTCY

Most investors think of bankruptcy as a bad thing. As a result they tend to avoid the stocks of companies that have been through Chapter 11. But, as mentioned above in “Background on Bankruptcy and Restructuring,” Chapter 11 can be very beneficial to a company. The bankruptcy process provides the company with an opportunity to solve most, if not all, of its problems. The company that emerges out of Chapter 11 will almost certainly be stronger than it was going into bankruptcy, and it may be stronger than many of its competitors as well.

However, because investors have such a negative view of bankruptcy, the stocks of these newly emerged companies are often under-followed and therefore undervalued. Brokers who recommended a stock before it went into Chapter 11 will have painful memories of the stock and are not likely to recommend it again. Similarly, the views of most investors will be tainted by their memories of the troubled company before it was transformed through the Chapter 11 process. As a result, they overlook the improvements in the company’s prospects and avoid the stock.

Post-bankruptcy stocks can be undervalued for another reason. Often when a company comes out of Chapter 11, it will give creditors new stock to pay off some or all of their old debts. While the creditors are grateful to get paid something, most of them would much rather have cash than stock, and so they sell the stock as soon as they can. This short-term selling pressure may depress the price of the stock for some time after the company comes out of Chapter 11.

Eventually, the selling by creditors will stop and investors will begin to realize that the company that emerged out of bankruptcy is much stronger than the company that went into Chapter 11. When that happens, the stock can appreciate dramatically. For example, when Kmart emerged from

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bankruptcy in May of 2003, its new stock began trading at 15. The stock dropped to 12 before beginning to move up, but by July 2003 it was in the 20’s, and it continued to move up steadily. The company merged with Sears in early 2005, and the stock (which took on the Sears name) approached 200 by the fourth anniversary of the company’s emerging from bankruptcy.

LOOK FOR SPECIAL PROBLEMS THAT DO NOT REALLY AFFECT THE BUSINESS

Sometimes a company will be in trouble because of one isolatable problem that is not really related to the ongoing prospects for the company’s business. Often the problem is related to litigation. If the company can solve this problem and remove the cloud over its securities, its stock and bonds may move up very sharply.

Sometimes the company will be forced into Chapter by its special problem. When this happens, the prices of its stock and bonds usually fall very sharply, and this can be a buying opportunity. But it is important to try to figure out which securities will benefit the most if the company can solve the problem. (See “Compare Common Stock, Preferred Stock and Bonds”.)

There have been a number of well-known examples of this type of situation over the years. For example, in 1987, Texaco lost a $10 billion judgment to Pennzoil in a dispute relating to an acquisition. Rather than post a huge bond to appeal the judgment, Texaco filed for bankruptcy, pushing its stock down as low as 15 (adjusted for splits). The two companies eventually settled their litigation, and Texaco was able to emerge from bankruptcy. Its stock jumped up to the mid-20’s after the settlement, and it eventually rose above 70 in 2001 when the company merged with Chevron.

More recently, Owens Corning was forced into bankruptcy by litigation relating to asbestos in products that it had manufactured decades previously. The company spent six years in Chapter 11 before crafting a settlement with the asbestos plaintiffs and emerging in 2006. The common stock did not fare well in the bankruptcy, but Owens Corning’s bonds jumped from about 20 early in the bankruptcy to 120 shortly before the company emerged.

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WATCH FOR FAVORABLE OR UNFAVORABLE MARKET CONDITIONS

One of the major advantages of investing in turnaround stocks is that they tend to move independently of the market in general. In other words, turnaround stocks can do well in both bull and bear markets. But there are certain conditions that are especially favorable for turnaround stocks and certain other conditions less than favorable

The very best conditions for turnaround stocks are when the economy is just beginning to improve after a slow down. The slower economic climate my have caused temporary difficulties for some companies who will recover quickly as the economy improves. In these periods of economic weakness, investors tend to be cautious and price-to-earnings ratios of stocks shrink. As conditions improve, investors get more optimistic, P/E ratios improve, earnings grow and stock prices rise sharply. In these periods of optimism, a well publicized turnaround will excite investors and they will rush into other prospective turnarounds.

Unfortunately, such periods of great turnaround successes often lead to periods when good turnaround investors must be especially careful. While most investors shun turnarounds, every now and then turnaround investing becomes fashionable for a brief period.

These periods when turnaround investing becomes trendy are few and far between, but serious turnaround investors should be on the lookout for them nonetheless. They provide a good opportunity to sell your turnaround stocks at a profit, and then sit back and wait for the good turnaround stocks to sink back down and once again become bargains.

WATCH MEDIA HEADLINES FOR OPPORTUNITIES

“Buy on bad news” has become an axiom among “contrarian” investors. While this axiom has some validity for turnaround investors, it must, like most Wall Street “wisdom”, be applied with great caution.

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Negative media headlines can be a great source of possible turnaround opportunities. Stories about big financial losses, industrial accidents, lawsuits and the like can cause almost panic selling of a stock. Often this selling causes a stock to go down more than it should and provides a buying opportunity. But it is not always a buying opportunity. Rather it should be a signal to watch a stock and apply some of the other tests of turnaround potential. Whoever said “bad news come in threes” must have had at least some basis for their theory, and it frequently happens that a negative headline turns out to be only the beginning of a stream of bad news. As pointed out above, stocks of companies on their way to Chapter 11 often take several large dips before they finally bottom out.

When an appropriate negative news story appears, put the company on your list of possible turnarounds, but wait for more signs before rating it a probable turnaround and investing.

COMPARE COMMON STOCK, PREFERRED STOCK AND BONDS

While the common stock of a turnaround candidate usually has the greatest upside potential, other classes of securities, such as bonds or preferred stock may offer good gain possibilities with less risk. The common stock has the lowest priority claim on a company’s assets, and in a liquidation situation there is rarely anything left for the holders of the common. The preferred stock has the next lowest claim on assets (at least among publicly traded securities). There may be several classes of bonds that have different levels of priority.

When there is still significant doubt about a company’s ability to survive at all – for example, in the early stages of bankruptcy – the most senior (i.e. having the highest priority claim on assets) bonds may be the best investment. When a company files for bankruptcy, it almost always stops paying interest on its bonds, and the bond price drops like a rock. It is not unusual to see bonds of Chapter 11 companies trading at a price of $20-30 for each $100 face amount of bond. This low price may be a result of investor over-reaction, however, and it may turn out that the bonds are secured by perhaps $60 worth of assets per $100 of bonds. If you buy a bond at $30 that is secured by $60

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worth of assets, you are almost guaranteed of doubling your money. You may have to wait a while to be paid, and you have to do your homework to figure out the value of the assets securing the bonds, but it can be very profitable. Junior (meaning having lower payment priority), unsecured bonds are riskier, but also worth looking at. If the company liquidates, the junior bondholders may receive little or nothing. But if the company successfully reorganizes, the junior bondholders often receive new securities (perhaps a combination of new bonds and stock) worth close to the face amount of the bonds. This is because publicly traded bonds often have a strong representative who plays a major role in the reorganization process.

Preferred stock often presents exciting opportunities when the company does not go into bankruptcy. In bankruptcy, the preferred is usually treated only slightly better than the common stock, probably not enough to justify the premium that you pay for the preferred.

The most interesting preferred are those that have “cumulative” dividends that are substantially “in arrears”. This means that the company has stopped paying dividends on its preferred, but its obligation to pay continues and the amount due to the preferred holders gets bigger (“cumulates”) each time a dividend payment date passes without a payment being made. The company must pay off this accumulated dividend obligation before it pays any dividends on the common stock or other junior securities. As the company begins to recover, investors realize that preferred holders might soon receive a large payment of accumulated dividends, and they bid up the price of the preferred stock accordingly.

Frequently, there will be classes of preferred stock or bonds that are convertible into common stock. In the case of a healthy company, the conversion feature may be quite valuable and command a price premium. In a turnaround situation, however, the conversion feature may not have much value. It will probably be worth something only if the convertible security was issued fairly recently and the conversion price is not too far above the current price of stock. Older classes of convertibles, where the conversion price is far above the current price of stock, must be evaluated as though the conversion feature did not exist – i.e. you must ask whether they are worth buying as straight preferred stock or junior bonds.

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One time when convertible securities can be quite attractive is shortly after a company emerges from bankruptcy. Companies frequently issue convertibles as part of their reorganization, or in a new financing shortly after reorganization. Because investors are wary of the new company as a result of the “taint” of bankruptcy, the interest or dividend rate on these convertibles tends to be quite high and the premium for convertibility tends to be quite low. Thus, you can get almost all of the upside potential of the common stock with a bonus of substantial interest or dividend payments.

Many turnaround companies have only one class of securities available to investors, but where there are different classes to choose from, it can pay to do a little extra analysis of the various options.

THREE

TWO OTHER KEYS TO

SUCCESSFUL TURNAROUND

INVESTING

T

hese 10 rules can greatly enhance your turnaround profits, but there are two other essential elements to successful turnaround investing: diversification and patience. Not every turnaround candidate will be as successful as you hope, and so you should not “put all your eggs in one basket.” Also, turnarounds, particularly bankruptcies, can take some time, and so you must be willing to stick with your investment and not lose heart.

Diversification is the key to any successful investment program, regardless of what you are investing in. It is essential for turnaround stocks, growth stocks, mutual funds, commodities, rare coins or whatever. Diversification is particularly important – and particularly easy – in turnaround companies. It is particularly important because no matter how well you pick your turnaround candidates, you cannot predict with certainty what will happen. A balky creditor or an external event, such as a fire, may kill a company that really should have survived. And if a company is liquidated, you will probably lose most or all of your investment unless you hold senior bonds. If you diversify though, an unlucky pick or two should be more than offset by one or two big gains from other turnarounds.

Discover How You Can Identify Turnaround Stocks 14

Diversification is particularly easy in turnarounds because of their low stock prices. Turnaround stocks frequently drop $5 a share, sometimes down to $1 or $2. Therefore, even a small investment, of as little as a few hundred dollars, can be spread over a number of stocks.

A typical, and very profitable, turnaround portfolio might look like this: ten stocks which will ultimately produce two big losers, two small losers or do-nothing stocks, four small winners and two big winners. Because your upside potential in turnaround investing is huge and your downside potential is limited, the winners will more than carry the losers and you will do very well if you diversify. But if you only buy one or two stocks, you could, through bad luck and no fault of your own, end up with the one or two losers and miss out on the profits that other turnaround investors are reaping.

Patience is also important. Even aggressive traders looking for short-term profits must be willing to wait for the turnaround company to make its move. Turnaround companies often take longer to sort things out than people initially expect. And it is better to get in too soon – and wait a little while – than to get in too late, after everyone else has recognized the opportunity and bid the price up. Worse still is choosing a good turnaround stock, but getting impatient and dumping it at no gain or a small loss just before the turnaround takes hold and the price soars.

One related warning is in order here. Because turnaround stocks are volatile and may take time to reach potential, they should not be your only form of savings or investment. Rather they should be part – and ultimately may be the most profitable part – of a broad-based and balanced savings and investment program.

Good luck. If you follow the rules discussed above, diversify you investments and have patience, you should realize substantial turnaround profits.