Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 177

What to look for in a profitable turnaround

We are always on the lookout for opportunities the market may have missed, misdiagnosed or underappreciated. One type of stock that falls into this category is the 'turnaround'. It can be defined in various ways, but in essence it involves a change from a poor quality company to a good one. This does not necessarily mean a company whose improvement relies on the economic cycle, such as a building stock benefiting from a housing construction boom. Instead, I mean corporate change that is more structural and enduring.

The upside

Turnarounds can be very rewarding for investors. Often the share price of a turnaround stock will reflect low expectations, extrapolating its difficult past without comprehending what it could possibly become. A successful turnaround can give rise to a double play. Firstly, the company materially improves profits, often dramatically so; and secondly, this leads to a turnaround in investors’ perceptions, leading to a re-rating of the company’s shares as the improvement proves sustainable and profits offer potential growth. This double play compounds returns for the shareholder, with for example a doubling of earnings and a doubling of the PE giving rise to a four-bagger (a rise in share price of four times).

In addition to the potential outsized returns, turnarounds can also offer diversification benefits. Turnarounds represent upside that is generally stock-specific, and as a result, performance has limited correlation with the rest of the market. The ups and downs of a turnaround stock will generally depend more on what is going on within the company than in the broader market.

The downside

On the other hand, turnarounds come with significant risk. A turnaround may not actually succeed as planned, it may waste considerable resources in its attempt, and underlying profitability may continue to deteriorate. In fact, this scenario is not uncommon and is best explained by Warren Buffett’s quip that “turnarounds seldom turn”. For this reason, turnarounds can become value traps, with the failure to turn further evidence of the company’s poor quality, justifying its lowly valuation.

There can often be a fine line between success and failure in any turnaround situation. That said, there are a number of attributes to look out for in identifying a potential turnaround success. In broad terms, one should consider what has been holding the company back, whether it can be changed, and as the turnaround strategy progresses, tangible signs of progress.

Sometimes they do turn

The first and perhaps most important attribute to look out for is the existence of a strong underlying business or assets that will allow the company to rise above its problems. One of Buffett’s greatest all-time trades was actually a turnaround situation called GEICO. The company is a US car insurer with a low-cost, direct-to-consumer model that allows it to price policies cheaper and earn decent margins. However, at the time of Buffett’s original purchase in 1975, it was facing near bankruptcy due to over-expansion, ill-disciplined underwriting, price controls in certain states it operated in, and an undercapitalised balance sheet. With a new CEO leading the charge, the company raised capital and embarked on a dramatic turnaround focused on reining in the expansion, returning underwriting discipline, and exiting operations in regulated and unprofitable states. From a position from which Buffett admitted there was a reasonable probability of losing his entire investment, GEICO slowly turned around and eventually made Buffett a mint (which it still does).

The key to the success was the strong underlying business that had lost its way, but was capable of re-finding its funk. It is much easier for a business with good bones to turnaround.

The rarity of operational turnarounds

It is also possible for an operational turnaround to succeed in making a fundamentally bad business good. However, structural reasons may make it nigh on impossible. As evidence, there are a large number of businesses forever trying to turnaround, with classic examples being CSR, AMP, Spotless and Primary Health Care. There are few that change fundamentally for the better.

One that has is Amcor. For a long time the company struggled in the largely commoditised packaging industry, and reflecting this, its share price barely budged for decades. A decade ago, new CEO Ken McKenzie started out on a turnaround strategy that involved divesting low-returning businesses, scaling up more profitable ones via acquisitions that also consolidated relevant markets, plant rationalisation, and instilling a sales discipline that focused on margin rather than volume. Perhaps owing to its inglorious past, it took the market some time to recognise the change, but those who did have enjoyed strong investment returns since.

Leveraging valuable assets

Amcor’s strategy was text-book for a turnaround for a structurally challenged company, one that we see echoed in the turnaround currently being undertaken at Treasury Wine Estates by CEO Mike Clark. And in contrast to Amcor, Treasury has some valuable brands to work with.

In fact, as in the case of GEICO, most companies that can successfully execute a turnaround have something valuable to work with. For example, Coles’ turnaround under Wesfarmers ownership starting in 2008 had the benefit of Coles’ large existing store network, with as many stores as Woolworths, and sufficient scale through a meaningful sales base. New management came in, revived store formats, loudly marketed lower prices, and grew customer numbers and sales strongly, helped out of course by an accommodative competitor in Woolworths.

Likewise, Caltex owned a very profitable fuel distribution business that was able to shine through once it reduced its low-returning and volatile oil refinery business; and TPG Telecom had an existing network and a decent customer base as it moved from loss-making to very profitable through scale-building acquisitions that also consolidated the broadband market.

What to look for

The examples suggest characteristics to look for in identifying when a turnaround might succeed:

  • a new CEO, often from outside of the company, carrying none of the company’s historical baggage and who can drive the turnaround strategy
  • a corporate restructuring, generally aimed at growing the higher-quality businesses, and exiting unprofitable ones
  • industry rationalisation, particularly as part of an attempt to beef up profitable businesses, with the added benefit of improving the industry structure
  • an accommodative industry, in which a struggling company is allowed to re-emerge, or where an industry as one works towards higher pricing and therefore profitability
  • a recapitalisation, with the effect of addressing an over-leveraged balance sheet, which affords the financial flexibility to get through any difficulties and allows investment in growth areas.

Conclusion

Turnarounds offer the opportunity to invest in quality that may not be readily apparent to most other investors, a scenario that generally presents value upside. Turnarounds, however, come with considerable risk, and it pays to stay close to the company in question. At BAEP, we invest where we have high levels of conviction. We will usually wait for genuine evidence that a turnaround is turning, most often through the company’s reported financials. Head fakes are common in this game. We’re happy to give up the first 20% or so if it means greater certainty. Generally, this still leaves plenty of upside as the market slowly starts to look at what the company may become.

 

Mark East is Chief Investment Officer of Bennelong Australian Equity Partners (BAEP). This article is general information and does not consider the circumstances of any individual.

 


 

Leave a Comment:

     

RELATED ARTICLES

Behind the headline profit numbers

Lessons from Peter Lynch and Dick Smith

banner

Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Retirement

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Property

Hey boomer, first home buyers and all the fuss

What is APRA worried about? Most mortgagees can easily absorb increases in interest rates without posing a systemic threat to the banking system. Housing lending is a relatively risk-free activity for banks.

Property

Residential Property Survey Q3 2021

Housing market sentiment has eased from record highs and confidence has ticked down as house price rises slow. Construction costs overtook lack of development sites as the biggest impediment for new housing.

Investment strategies

Personal finance is 80% personal and 20% finance

Understanding your own biases and behaviours is even more important than learning about markets. Overcome four major cognitive biases that may be sabotaging your investing and recognise them in others.

Where do stockmarket returns come from over time?

Cash flow statements differ from income statements and balance sheets, and every company must balance payments to investors versus investing into the business. Cash flows drive the value of the business.

Fixed interest

How to invest in the ‘reopening of Australia’ in bonds

As Sydney and Melbourne emerge from lockdown, there are some reopening trades in the Australian credit market which 'sophisticated' investors should consider as part of their fixed income portfolios.

Shares

10 trends reshaping the future of emerging markets

Demand for air travel, China’s growing middle-class population, Brazil’s digital payments take-up, Indian IPOs, and increased urbanisation are just some of the trends being seen in emerging economies.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.