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At The Turnaround Letter, we believe that the essence of turnaround investing is profiting from a substantial upturn in an underperforming company’s fundamentals. Simply put, it’s buying when things look bad but are actually about to get a lot better.
What is the most powerful factor in successful turnaround investing? Making sure there is a solid and clear reason that the fundamentals – revenues, costs, balance sheet – will improve. What is the most important way to reduce risk when selecting a turnaround stock? Buying at a significant discount in underlying value. In other words, buying with a margin of safety.
Most of the mistakes in turnaround investing violate one or both of these principles. If fundamentals don’t improve (or worse, deteriorate further), the investment will almost certainly not be successful. If the valuation is not attractive, the over-paying investor not only has reduced their upside potential, but also risks greater downside should the fundamentals stall out.
It can be tempting to look at a depressed stock and think, “it used to trade at 40 and now it’s at 8 – therefore it must be a bargain.” Unfortunately, the fact that a stock once traded at a higher price does not guarantee that it will ever get back there. One big reason that a stock trades so much lower than before: its earnings potential or assets have deteriorated. Without some fundamental improvement, the share price will continue to lag, or worse.
You want to understand why the stock price has declined. Then identify what fundamental change will reverse the company’s fortunes. Is the management taking new actions to address the issues? Is the industry cycle turning up? Is something else improving? Only then can the stock have a chance to recover. And remember, the former $40 stock doesn’t need to fully recover. If you buy it at 8 and it goes to 16, even though it’s down 60% from its prior price, you still have a 100% gain.