Let's flash back 31 years ago to a brokerage office in Merrillville, Indiana.
There you will find a young Steve Reitmeister doing a summer job for his father. Sure I was trying to earn extra spending money. But, more importantly, I was a budding young capitalist eager to learn about investing in stocks. So who better to learn from than my father, a seasoned Certified Financial Planner.
So dad pulls out the, seemingly 50 pound, hard copy Value Line Investment Survey binder. He reviews the basics with me. Such as understanding that owning stocks is about taking an ownership stake in the company. And the healthier the company and the more earnings it generates, the higher the stock price will go. He then leaves me for a while to do some research on my own.
I was immediately drawn to the valuation section for each stock. In my mind it made no sense to buy a stock that they only expected to go up 30-50% when some had the potential to go up 100%, 200%, even 300%.
My dad tried to explain to me that they are discounted for a reason. Most of them were troubled companies producing poor earnings reports and suffering from declining stock prices. This made them risky investments and perhaps should be avoided.
No matter how hard he tried, I could not be swayed. I wanted the chance at the higher potential return. Right then and there, it was clear I was a turnaround investor.
The story since then is one of some glorious successes (buying Amazon at $8.50 and Priceline at $25 after the Internet bubble burst). But also a story of some shocking failures (watching shares of @Home and CMGI go from bad to non-existent).
So the purpose of this article is to share some lessons learned over these 31 years with other investors who enjoy the thrill of profiting from a great turnaround story.
Lesson 1: Why Pursue Turnaround Stocks?
There are many ways to invest successfully. Yet the appeal of the turnaround is broad based. That's because no one will pat you on the back for buying an obviously good stock like Apple at $250 and selling it for $300.
The joy of the turnaround story is that it's often a discarded or unknown stock that no one else wants to touch. And when it goes up, you get great satisfaction in the "I told you so" moment when you share the story with others. (Many of whom didn't take your advice in the first place. Shame on them ;-)
But more importantly, there is great satisfaction in the outsized returns that occur when you guess right on a previously neglected stock. And that is the best reason of all to actively seek out these turnaround candidates.
Lesson 2: Wait for the Proof
The one thing that all my turnaround failures have in common is that I got in too early. Meaning I was buying in on the way down, hoping and praying that the turnaround would take place. Too often the turnaround did not materialize and my hard earned money was washed down the drain.
So the key is to have the patience for the company to show you undeniable proof that the turnaround is occurring. The clearest form of proof is when the company delivers a big positive earnings surprise that Wall Street analysts fawn over with greatly increased earnings estimates for the future.
Yes it's true that the stock will jump on that news and you will not grab the stock "exactly" at the bottom. However, your entry point will be plenty low in the grand scheme of things. Plus you have now GREATLY increased your odds of being in a winning and timely trade.
Lesson 3: Choose Growth Stocks
You are bound to discover that a turnaround story can take place in any industry with companies both big and small. However, the best returns will come from buying the stocks that have the highest growth rates. That is because once the turnaround takes place the PE will start to rise from abnormally low levels. The higher the growth rate of the firm, the more the multiple will expand and the greater your final return.
My two previous success stories of Amazon and Priceline prove out my point. These stocks are up 2000% and 1500%, respectively, since I bought them nine years ago. That's because they are still experiencing the phenomenal growth associated with being Internet e-commerce leaders. However, we all know I would not have fared as well if I invested in more pedestrian stocks like a phone company or bug exterminator.
Long story short...focus on growth stocks for the best turnaround profits.
Lesson 4: Don't Forget Value
Not every stock whose price has gone down is a bargain. That is because stocks have so much premium in their share price that it takes a long time to squeeze out the excess after the bad news hits. For other companies it's not really a bargain because future estimates keep slipping faster than the share price decline; thus making the PE actually rise.
Given the increased risk inherent in turnaround plays means that you should be buying at a discount to peers to make it worth your while. PE, PEG and Book Value are all useful tools. But certainly consider the lesser used Price to Sales ratio, which quite often unveils the best opportunities.
Where to Find Turnaround Stocks Now?
Given my love of turnaround stocks I commissioned our research team to develop a strategy to help investors discover more of these profitable trades. To say that we were successful in this endeavor would be the understatement of the decade.
The starting point for this project was noting that true turnarounds can easily be detected when a company's earnings estimates suddenly reverse from downward to upward. So the proof of the turnaround occurs when a stock makes a sudden leapfrog from a lowly Zacks #5 Rank ('Strong Sell') or Zacks #4 Rank ('Sell') all the way to a Zacks #1 Rank ('Strong Buy').
On top of that we add in key measures of earnings growth and reasonable valuation to create a turnaround stock picking strategy that beats the average Zacks #1 Rank stock by 2.5 times. Yes, that means the average gain was +45.4% per year. (And that gain was over the past 10 years. As you probably remember, that 10 year stretch wasn't the best for stock investors and yet this turnaround strategy just kept picking winner after winner).
So I highly recommend that you check out our new Zacks Rank Turnaround Trader now, because we must limit the number of investors who share its recommendations. There has already been a flood of investors joining at special Charter Member terms. This arrangement ends Monday December 20, but the service may close to new investors at any time.
