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Five Things to Look for in a Turnaround

Turnarounds are risky, but if they work that can often create staggering investment returns as a deeply discounted share rebounds to fair value and, perhaps even, moves into a higher rating as a growth stock as the rest of the market grows in confidence.

But how do you know if a turnaround is going to work?

The short answer is that you don’t know. But, try focusing on the following aspects when analyzing a business for the potential of turnaround prospects:

1.) Solvency: The less debt you have, the more time for the turnaround you get

Debt is a time sensitive funding structure as interest is incurred over time and, particularly in structured debt, have set covenants, repayment schedules and/or redemption details and dates. This include net overdraft positions and even off balance sheet funding (via operating leases and other more “creative” structures).

In other words, the more debt a turnaround business has, the less time it often has to “get things right”. It may be half way to turning the business around when the debt suddenly falls due or the lender calls in its breach of debt covenants, and then–very quickly–the business can hit the wall.

Hence, the less debt a turnaround has, the more time it has to get things right. And the more time a turnaround has, the greater the odds that it will eventually come right.

2.) Liquidity: More cash coming in than going out keeps you in business

Even if a turnaround has no debt, if its operations year after year suck up cash and it never generates any free cash flows, eventually its resources will exhausted and it will need to borrow.

On the hand, the stronger the operating cash flows in a business, the more the business can use these cash resources to shore up other aspects of the business, service debt, payout retrenchments, and so on, in the steady progress towards sustainable profitability.

We would go so far as to say, no matter what IFRS profits are reported, if a company year in and year out produces large operating cash inflows, the business will continue to operate just fine. And, if a business can continue to operate, then it has more time to effect a turnaround and the odds increase that it will eventually come right.

3.) Profitability: Pricing power makes for easier turnarounds

Here is a published an article discussing the major difference between a business’s Gross Profit (GP) margin and its Operating Profit (OP) margin (Insight into Operating & Gross Margins).

In essence, a high GP margin implies a business that has a strong competitive advantage, particularly with regards to its pricing power in its good and/or service. OP margin is more a metric reflecting efficiency, returns to scale and/or “bloat” in a business’s operating structure.

We believe that it is always easier (i.e. improves the odds of successfully) turning around a business that has pricing power, rather than one that is a price taker.

4.) Turnaround plan: A bad plan is better than nothing, but a good plan is the best

Has the business even admitted that it is doing a turnaround? This may sound like a funny question to ask, but some business’s management are in such denial about what a bad business they are running that they cannot admit that they are trying a turnaround, and thus will likely fail. Avoid these.

Then next level is that, at least, management admits that it is performing a turnaround. That goes hand-in-hand with having a “Plan” for the turnaround.

Consider whether the Plan is a good one, though? Be particularly skeptical when it is the same management that originally ran the business into the ground that are suddenly offering this Plan as a solution… If they messed up once, the odds are increased that they will do so again in the future.

Does the Plan admit what went wrong? Does the Plan state what needs to be done to address what went wrong? Does the Plan cover all bases and does it sound reasonable to you?

Not all plans are good plans, but having a plan is better than nothing.

5.) Management: Are they committed and convinced?

This last point is actually tied into (4) above, as management are the ones who draft the Plan and have to execute the Plan.

Only with hindsight will we know if the execution of the Plan is actually good or not, as investing into a turnaround is investing before the Plan becomes reality. So, try to get a sense for whether management will execute the Plan well or not, but it will remain a guess at this stage.

Rather, consider if management are committed. Have they bought large amounts of their own stock? Are they large shareholders in their own turnaround? Have they underwritten their rights issues? Have they signed multi-year employment contracts?

If management has no skin in the game regarding the turnaround, the odds are that they are not convinced that it will succeed.

In conclusion, each turnaround really actually needs to be judged on a case by case basis. But, this list should at least give you a starting point from which to try gauge what the odds are for success. And, have no illusions, turnarounds are just like any other investment: they have odds that they will succeed, just as they have odds that they won’t.

Five Lessons with Liquidity

Besides all the usual skills and knowledge that goes with investing in stocks, operating in the small cap space forces you to master handling positions in low liquidity stocks.

Here are five rules to help you handle low liquidity stocks:

1. Stretch your time horizon

Low liquidity makes exiting a position in a stock challenging and, often, costly. But, what if you never exited an investment? Suddenly the investment’s lack of liquidity really would not matter to you (or, at least, matter less).

Forever is a long time, though, but this is also work if you take much longer-term perspectives with your investments. This not only allows your gains to far more exponential (i.e. 10-baggers) from which a small liquidity cost of exiting is minor, but it also can lead to situations where you bought into an illiquid stock that re-rates over years, becomes popular and when you sell your position the market’s liquidity is sufficient to barely notice.

For an example of this latter phenomenon, looks at how the Rand-value traded in EOH has steadily grown over the last decade during which the stock re-rated and the share price exponential rose.

2. Buy with a sufficient margin of safety

By their very definition, low liquidity stocks cannot absorb significant volumes of their script being sold in the market. Thus, low liquidity stocks could see their share prices crash for no apparent reason other than one or a couple of random sellers have decided to dump their positions.

You need to be comfortable enough that the investment you have made into the low liquidity stock is sufficiently discounted against its intrinsic value and future prospects that, if the share price halves on a couple of trades, you could not care less. If fact, perhaps you even consider buying more (see (4) below)?

The only way you satisfy this rule is to thoroughly research and understand the company and then diligently value the stock from all angles. If the stock still appears deeply discounted against your valuation(s) of it, you are likely buying it with sufficient margin of safety that the short-term volatility of its share price can be ignored in favour of your (1) long-term time horizon.

3. The bidding spread

The spread between the bid and offer of a stock is called the ‘bidding spread’. Bidding spreads are actually a cost. The wider the spread, the worse the spread is considered and the greater it may cost the investor.

Let me phrase it like this, if the bidding spread of a stock was 5% and you had bought the stock a second ago and were forced to sell it immediately, you would have to take the highest bid. As that bid is 5% below the Offer, thus it is likely 5% below where you bought the stock. In this case, the bidding spread would cost you 5% of your investment.

Now bidding spreads tend to be ludicrously wide in low liquidity stocks, but if (1) your time horizon is sufficiently long and (2) the stock is discounted enough against its valuation and upside potential, then why haggle about a couple of percent in the bidding spread?

Instead of trying to be clever and placing a low bid (where you could save a couple of percent, but also risk missing out on the stock’s upside by never owning it at all), rather simply cross the bidding spread and pick up whatever stock you want (assuming it is available). Why worry about losing 5% on a bidding spread? If you are never in the stock you risk missing out on 5,000% upside!

So, if (1) your time horizon is sufficiently long and (2) the stock is discounted enough against its valuation and upside potential, then you should be comfortable enough about the value of the long-term position in the stock to do this.

4. Averaging up and averaging down

Sometimes the stock is so illiquid that even if you (3) cross the bidding spread, you would not be able to pick up sufficient script (or sufficient script at the prices you are willing to pay for it). In cases like this, building a position can take time, so consider “averaging up” or “averaging down”, depending on which way the stock is moving at the time.

In other words, if the stock is rising, steadily pick up chunks of it raising your average entry price. If the stock is falling, steadily stagger bids lower and lower and pick up more at lower prices, lowering your average entry price.

This needs to judged on a case-by-case basis and is not always appropriate. But if you have done your homework and are comfortable that you are (2) buying the stock with a sufficient margin of safety and (1) have a long-term time horizon, then you are simply using the market mechanisms to your advantage.

5. Absolutely only ever invest cash you do not need

All the rules from (2) to (4) are meaningless if your (1) time horizon is (forced to suddenly become) too short.

While you can buy into a low liquidity stock with all the right intentions of holding it for many, many years, if somethings happens (probably in your personal life) and you become a forced seller of that stock, then all the above rules are meaningless and the low liquidity will likely cost you dearly.

So, only make investments into low liquidity stocks with funds that you are absolutely, positively sure you do not and will not suddenly need.

The article originally appeared on SmallCaps.co.za.

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