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When you are looking for the ideal turnaround stock, you want all three primary ingredients: a struggling business, a laggard stock price and, critically, an outlook that is about to show significant improvement.
There are always plenty of struggling companies. No matter how strong the broad economy is, some companies will fall behind changes in technology or customer demands, or needs to deal with an industry down-cycle.
Similarly, there will always be stocks that have lagged the broad market. Investors’ preference for growing companies and momentum stocks will always mean that some stocks just can’t keep up.
However, with U.S. stocks well into their eighth year of a bull market and the economy showing increasing signs of strength, finding ideal turnaround stocks – those with all three ingredients – can be a needle-in-the-haystack project at best. What is an investor to do in a seemingly barren value stock landscape?
One simple approach which can be used regardless of what the market is doing is to screen for S&P 500 stocks that have gone nowhere in the past five years. Our thinking: with the market up over 50%, stocks that were unchanged over the period either had real fundamental problems or were unjustifiably out of favor.
In our July 2016 Turnaround Letter issue, we used this approach in the article titled "Turning Back the Clock Five Years: Good Companies Whose Stocks have Gone Nowhere." We looked at companies with healthy balance sheets, good management teams, and well-known brand names and in many cases attractive dividend yields…we purposely excluded energy industry stocks. We found seven stocks that met the test of being unreasonably out of favor:
Performance is based on price changes only, and excludes returns from dividends.
* Alcoa price on July 1 is adjusted for the 1:3 reverse split on October 5. Price for December 22 reflects all shares of new Alcoa and Arconic as received in the November 5 spin-off transaction.
Since our July Turnaround Letter, our seven value stocks have produced an average return of 15.9% compared to the 7.5% return of the S&P500. Three have returned over 25%, and all seven have gains of at least 4%. BorgWarner’s value impressed us enough to become our Featured Recommendation in the August 2016 letter.
In this bullish environment turnaround opportunities may be a little more disguised but you can still find them by applying the basic turnaround investing tenants.