One particular type of investing style that I had always wanted to try but did not have the courage to do so revolved around looking for companies that had fallen out of favour with investors due to declining profits and weak fuure prospects. The exact opposite of growth stocks, they suffer from PE re-rating every now and then when they publish their quarterly reports showing declining figures in every single aspect of their business. This approach however, involves looking for exactly such companies. The bleaker the prospects, the more suitable it is as a candidate for investing.
Now, why would an investor want to look at a company which is losing money? The reason is that this particular style of investing banks on the hope that the management will keep the company afloat for as long as they can, and hopefully, be able to survive for long enough until the company turns profitable again. They reason, that these businesses will naturally find a way back into profitability as management would try means and ways to keep the company afloat, although I believe that this proposition itself is up for contention. Nonetheless, the trick is in finding such companies who have enough stockpiles of cash to tide them through these trying periods, so that in the event they turn profitable again, the company will be back in favour with investors.
Benjamin Graham popularised the term 'Net net current asset value", which is the current assets net of total liabilities. He set a criteria of buying into a company if the market capitalisation was at 2/3 the value of its NNCAV. For a compay to be priced at this level, the markets would probably be so pessimistic about the prospects of this stock that they are unwilling to pay even the NNCAV of the company. Now, there probably aren't that many companies out there trading at such levels, so you could tweak the criteria a little, according to your own comfort level. Then, the next step is to evaluate the balance sheet strength of such a company. Determine the cash burn rate of the company, i.e. the rate at which the company is using up its cash. For e.g., if the cash holdings of the company is $8 this quarter, and $6 the next, then the company is probably using up cash at approximately $2 per quarter. So, making an intelligent guess, you might figure out that the company might be able to hang around for probably 2-3 more quarters. Now, depending on your comfort level, you might want to look for a company which can hang around for at least a year or two.
What then about the business model? Is there a need to look into the sustainability of the business model? Well, the reason why I quoted the "cigarette butt" investing phrase is because the company that you are looking at is probably gonna be around for only a short period of time before it finally folds. Good for just one more puff, but nothing more. The very fact that the company is in dire straits at this moment of time bears testimony to the inferior business model of the company, unless of course there are other reasons that you believe resulted in the company's current situation. But do of course be cautious in your stock picking. Other than the cash burn rate, the liquidity value of the company could be another part that you want to consider. NNCAV is simply just a measure of how the company's working capital can cover its long-term liabilities, but this assumes that in the event that the company really does wind up, inventory and other receivables may not be totally redeemable at the price indicated on the balance sheet. If the company you are looking at it is in a sunset industry, you might want the company to be trading at a huge discount to its NNCAV before you even consider buying up its stock. There are also many other factors that you want to consider, things like its operating cash flow(profits dropping but operating cash flow increasing would be a good sign). In essence, do your homework with regards to its financial strength, but you could be forgiven for not wanting to take a second look at its business model.
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6 comments:
Hi patrick,
Another excellent read! Turnarounds are companies that have been beaten down by losses, in a depressed industry, and are barely dragging themselves out of bankruptcy. It is very profitable if they are able to return to the black again. I'll leave readers to decided if it is a short or long term play. If it is a long term play, we are looking at multi-baggers.
One turnaround I've noticed is ChinaAOil, however their steam did not last long. Trading oil is difficult business. So I will label it as a short term play. A change of management did a good job in restructuring the company to make it profitable, but it is not a good company in a bankrupt situation. One would have a 1 bagger if they have bought it during the restructuring 1 year period.
I do not have the statistics, but more than often there are more failed turnarounds than successful ones.
A failed turnaround that I've participated in is ChinaACorp, former ACMA Ltd. It is like making bets, you are never 100% sure that the company would recover. In fact the company is not shareholder orientated as they struggle to issue warrants to delay their demise.
Like Warren Buffett always say, "time is the friend of a good business but the enemy of a lousy business". If it is a good company in a bad situation, do the math, do the probability and go for it. But if it is a lousy business no matter how cheap the company is, the price will continue to be cheap.
Another thing to note, turnarounds are not to be mistaken as cyclicals. Turnarounds are no growers, more than often declining businesses. Cyclicals are in an industry that expands and contracts periodically. Eg, car company.
My 2 cents worth. :D
Cheers,
Cheng
Hi patrick,
For me, I'll avoid turnarounds. It's already hard enough to find out good business, so why make it harder by investing in turnarounds? Besides, my accounting knowledge is less than stella, so unless I've got very strong reasons to believe in the new business or new growth engine that the company rolled out, I'll gladly put it in another company which had shown consistent earnings in the past. The market isn't short on these :)
hey patrick, ive posted an analysis on swiber's Q208 results and you should be able to find answers to why i feel its an undervalued stock there.
feel free to leave your comments, would love to hear them
Hi LP and patrick,
Valuating turnarounds are very challenging. The reason for their low valuation may be that investors valued it at liquidation prices. Hence, inventories, plants and machinery will be a lot lower than balance sheet valuation.
Since we are not an insider we can only guess how much it will be sold at the point of time. The longer the company prolongs liquidation the lower the valuation due to operating costs.
This is just one case scenario for a loss making company with little future prospect.
Thanks. Well for myself, I'm choosing to stay on the sidelines. For one, the majority of the investors are seemingly on the sidelines, probably watching the Olympics, as evident from the low turnover. Ain't likely that there will be any interest in such companies for now, and with so much uncertainty, I do feel it's wiser for me to steer clear. But only for now.
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