One of the obvious keys to making money in investing is to avoid making mistakes. Therefore, we thought it worthwhile to reflect for a moment on some of the biggest mistakes we’ve made--and seen other investors make--over the years. If you can avoid at least most of the following pitfalls, you will greatly enhance your ability to make money in turnaround stock situations:
Mistaking a low stock price for being cheap
Many stocks trade at low price for good reason, and without some sort of a catalyst will never rebound. Warren Buffet once said, “Turnarounds seldom turn.”
Paying too much attention to price history
This is related to the previous point. Many investors look at a stock and say something like “it used to trade at 30 and now it’s at 3—therefore it must be a good thing to buy.” Unfortunately, the fact that a stock once traded at a higher price does not guarantee that it will ever get back there. You must find a fundamental reason why the stock will rebound.
Confusing secular and cyclical problems
Sometimes a company or a whole sector will be cyclical and regularly move up and down because of economic or other factors. In that case it makes sense to buy the stock when it seems to be near the trough of a cycle. However, sometimes the problems are not based on short-term cycles but rather very long-term or even permanent trends. Often these secular trends are related to product obsolescence. For example, many paging companies failed after the cell phone gained wide acceptance. And today, investors are wondering whether traditional newspapers will disappear in the coming years.
Being too early
This is a problem for many value-oriented investors because they often recognize the opportunity in a battered stock well before the rest of the market. However, this problem is not so serious as long as you avoid the next pitfall.
Not being patient enough
Turnarounds can take quite a long time. And even after the company has begun to turn, it can take the market a while to recognize that fact.
Being too patient
Unfortunately, it is also quite possible to be too patient and stick with a stock that will never rebound. This often happens in conjunction with one of the other mistakes. There is no easy way to determine how much patience is appropriate. You just have to periodically re-evaluate the fundamentals of each position.
Not diversifying enough
It is easy to get mesmerized by the gain potential in a particular low-priced stock and put too much money in it. It is important to remember that turnarounds are inherently risky. Even if you avoid most of the pitfalls mentioned here, events may not work out the way you expected. The best way to manage this risk is through diversification.
Not paying enough attention to the debt
Stock comes at the very bottom of a company’s capital structure, and all other creditors have to be satisfied before any value can go to the stockholders. Therefore, if a company has a large amount of debt, that increases the risk that a stock may fare poorly. You can often get a sense of the magnitude of this risk by looking at the price of a company’s bonds. If the bonds are trading at a fraction of their face value, that can be an indicator that the stockholders are in for trouble.
Buying the stock of a company in Chapter 11
This is closely related to the previous point, as well as the first two we mentioned. Very rarely will a company in Chapter 11 be able to generate enough value to get down to the stockholders. Therefore, even though a Chapter 11 stock may be trading at a very low price, it is most likely not a good buy because it will probably go a lot lower, frequently to zero.
Putting too much faith in insider buying
Insiders don’t always have the best view of what is really happening to their company. Often they will be blinded by their loyalty to the company or be overconfident about their ability to turn the company around. It is not unusual to see top executives add to their holdings shortly before a company goes bankrupt.
There are undoubtedly other mistakes that can be made, but these strike us as the most likely blunders in the turnaround stock sector. Just by being aware of them, you can improve your investment performance.
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