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George Putnam, one of the country's leading turnaround and distressed investing professionals, shares his timely insight on the economy and turnaround investing opportunities.

Distressed Investing: How to Evaluate Turnaround Prospects

In this next note in our continuing series on investing in distressed securities, The Turnaround Letter explores the next step as you evaluate your possible investment. After you’ve determined what got the company into trouble, you want to evaluate whether it can get out of trouble.

Highlights: When a company is distressed, its assets are probably worth less than its debts. The best indicator of whether a distressed company will recover is its willingness and speed in dealing directly with this reality. To get out of trouble, the company must find cash (to buy time) and improve the value of its assets.

First, look for sources of cash that the company can tap. Cash can come from selling operations and assets that aren’t critical to the company’s future and from money-losing businesses. Second, see if core operations can become more valuable. This usually requires new management and a credible plan. Make sure the plan is not merely doubling-down on the prior causes of distress.

Discussion: Distressed companies are upside-down: their assets aren’t worth enough to satisfy their debts. Without a doubt, the best indicator that a distressed company will recover is its willingness and speed in dealing directly with this reality. Pure luck may intervene to save the company, but don’t count on it – in nearly every distressed situation, ignoring reality is a strategy for failure.

Facing the new reality requires the company to find cash to give them time to complete the turnaround. It means looking objectively at every asset to find ways to maximize their value.

So, the first part of your analysis is to look for ways that the company can find cash. Assets and operations that aren’t critical to the company’s future can be sold and can plug cash drains. These can include non-core operations, money-losing divisions, under-utilized assets and real estate that would buy the company time and flexibility without noticeably harming the core operations. Even if a business loses money, someone will be willing to pay cash for it.

Second, see if core operations can become more valuable. Are there well-known brands and product lines that provide real value to customers and can serve as the foundation for recovery? Are overhead or research expenses unusually high? Is the business poorly managed, laden with outdated processes, stale products and weak customer service?

Improving the value of core operations usually requires new management and a credible plan. Since weak or dishonest management is the leading cause of distress, it is unlikely that the management team that got the company into trouble can extract it from trouble. Replacing senior management with capable leaders that approach problems with a fresh perspective and have no attachment to prior strategies or operations is a strong indicator that a company is serious about addressing its new reality.

A credible plan provides a roadmap to help you evaluate what a post-recovery company might look like. It includes strategic priorities, financial goals, specific plans to improve day-to-day operations and capital structure improvements. Some plans essentially amount to a doubling-down on the previously failed strategy. You want to avoid these – go with a strategy that reverses or at least avoids the prior causes of distress.

Importantly, a credible plan buys time with creditors and provides you, the possible investor, with milestones for measuring progress. Milestones also exert pressure on management to execute. There are other indicators that the turnaround might be successful:

  1. Supportive workforce – employees that remain loyal and focused, particularly for long-time and highly-regarded talent. If the company has a unionized workforce, the unions may need to adjust their compensation structure for the company to survive.
  1. Reasonably stable near-term environment – minimizes external challenges while the company focuses on improving its internal operations. This stability also supports the valuation of any operations and assets that might be divested.
  1. Opportunities for improvement – launching new products/services, increasing penetration of existing or new markets, eliminating costly/unnecessary business practices and other ways that a company can improve its cash flows and value.

If the company can find enough cash to provide time for a recovery and has a credible plan led by capable new management, it could be a good investment. Your next challenge is to figure out what all this is worth. We will explore this in our next note.

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Puerto Rico Government Bankruptcy: Uncertainty But Also Investing Opportunity

Because of special tax law provisions that exempt the territory’s debt from not only federal taxes but also state taxes in every state, the bonds are widely held by investors across the country. Since the legal action is under a new law that has never been tested, there is tremendous uncertainty about how much creditors will recover and how long the process will take, but there may be opportunities for stock investors to profit from the island’s restructuring as well--perhaps with less downside risk than in many of the bonds. We found four public companies based in Puerto Rico that could benefit from stabilization in the island’s finances as well as three major insurance companies with exposure to Puerto Rican debt. Read More.

Market-Beating Profit: The 200+ Club

Turnaround stocks present a unique opportunity for savvy investors to buy in at bargain prices. Take a look at this list of just a few of our purchase recommendations that have realized a return rate of 200% or better:

Value Investing Stock Profit

* Bristow remains in our active portfolio (currently as a Hold), and 2,320% gain is as of 4/11/17.

Five Struggling Stocks That Will Turn Around

 

stock market advicex

 

Kiplinger points out that despite the post-election stock market surge, not all stocks have benefited from the uptick: "More than 100 issues in the S&P 500 have fallen in price this year, including dozens that have slumped by more than 10%....Yet these stocks won’t all stay in the dumps forever. Some will mount a comeback in 2017, making it an opportune time to try to identify the best candidates."

 

Quoting George Putnam, Kiplinger details five value opportunities for the new year.

 

Learn more about Putnam's investing success with turnaround stocks.