“Many shall be restored that are now fallen, many shall fall that are now in honor”.
One doesn’t need to look far to understand why Ben Graham quoted Horace on the opening page of his value investing classic, Security Analysis.
The list of 2016’s best performing stocks is loaded with those that had fallen in recent years. Metcash and Whitehaven Coal have doubled off their lows, while Infigen Energy, which had caused shareholders (including us) nothing but pain for the past five years, is up 160 per cent this year.
While buying troubled businesses might seem like a sure way of making money, the year’s worst performers show that it isn’t quite so simple. If you had bought Dick Smith, Surfstitch or McAleese hoping for a rebound, you would have lost almost all of your money.
So how do we sort the wheat from the chaff? Here are the four things we look for in a turnaround.
Revenue to work with
Cost problems are much easier to fix than revenue problems. A company whose margins have deteriorated but still has consistent and sustainable revenue is a much better candidate than one where a lack of revenue is causing the problem.
This is particularly the case in businesses where the main assets are human beings, like marketing agencies or IT services firms. Shrinking businesses shed staff – usually the best ones first – which only causes revenue to decline further. So look for reliable revenues (long-term contracts can be great) and cost problems that can be fixed.
Assets to stand by
I don’t just mean physical assets, I mean any asset in the business you can hang your hat on. If worst comes to worst, the company can sell a part of itself and realise some value. Our most successful turnaround investment has been utilities contractor Service Stream, which is up fourfold in the past year.
The end result has been far better than we expected, but the initial investment was predicated on two divisions that were unaffected by the company’s disastrous foray into NBN construction. Those divisions gave the company earnings and cashflow with which to fix its other problems. It could be a piece of land, shares in another company or a division that can be sold, but you want something concrete as a fall-back for your investment.
Hustle to do the hard work
It takes a different type of manager to make a turnaround work. You don’t need a grand visionary or motivational CEO, but someone who is prepared to roll their sleeves up and get stuck into the dirty work of making hard decisions and cutting costs.
Vision Eye Institute is another of our successful turnarounds in recent years, and it was largely thanks to quietly spoken CEO Brett Coverdale.
You won’t see Brett in a designer suit on the front page of a management magazine, but when it came to negotiating with banks, ophthalmologists and generating cashflow, he did everything shareholders could have hoped for. It’s not the most appealing job, but a good turnaround candidate needs the right management and appropriate incentives for the task at hand.
Time to be on your side
Finally, you need the company to have enough time for the turnaround to take hold. That either means having a strong balance sheet (plenty of cash) or debt that isn’t due to be repaid for a long time.
Another of this year’s stellar performers is mining services company Ausdrill. The company has clearly had too much debt for a few years now but the money it owes is mostly US bonds which are light on covenants and not due to be repaid until November 2019.
That flexibility has given it enough time to generate cashflow, sell a couple of businesses and pay the debt down to sustainable levels.
Turnarounds usually take longer than expected and prospective investors should look for signs the business will survive long enough for shareholders to reap the benefits.
Four for the coming year
So what are some stocks on the ASX today that might meet these criteria? In our own portfolio I’d suggest another mining contractor, Macmahon Holdings could be a good candidate. After a turbulent few years, the company now has net cash on the balance sheet, a handful of long-term contracts and a CEO who has proved his mettle.
Oil services companies MRM Offshore and Matrix Composites and Engineering are both badly beaten up and potential beneficiaries of higher oil prices, although MRM doesn’t meet the balance sheet criteria and Matrix is only a tiddler.
Finally, to round out the four, I’d highlight pawn shop operator Cash Converters.
We don’t own the stock and there are plenty of regulatory risks to worry about, but the share price has more than halved, the company’s balance sheet is strong, the managers are highly engaged and, while its business is an unsavoury one, we expect the government prefers a profitable Cash Converters to the black market.
You could, perhaps sensibly, draw the conclusion that investing in turnarounds is a risky business and not for the faint of heart. As the start to 2016 shows, however, it can be a highly prospective space for the diligent and enterprising investor.
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