To do so, they buy at lows and sell at highs, but the amount of time it takes for a stock’s price to appreciate may be more. Also, there may be times when the stock may go through bear runs.
This becomes even more challenging considering the changing dynamics of industry over a longer period of time. New players in a particular sector are constantly rising to shine. The trick is to identify which company has the highest potential.
One such strategy is to identify turnaround stocks. These are stocks of companies which have gone through a phase of weak financial performance and share prices have been beaten down. The idea is to find companies that are likely to identify issues that lead to a weak performance and change their business strategy to become profitable again.
Here are some of the characteristics of turnaround stocks:
The potential of a stock to outperform is always dependent on the ability of the company to post profits. As a result, one of the key characteristics of such a stock is that the company admits its error and is willing to make changes. Invariably, this involves management restructuring. This is because it is easy for a new executive to accept the flaws of past strategies.
There could be changes in the external environment that is now more conducive for companies in one particular sector to grow. For example, the falling rupee hurt companies that depended heavily on imports. With a stable rupee, these companies would get into a phase of managing their costs better than before. High inflation also affects input costs. It would be a good idea to identify companies that reported a loss due to rising input costs and rupee fall. Companies talk about factors that affect their performance each quarter in their financial statements. They also outline strategies to work their way to profitability in these statements.
The new management then identifies the company’s problems and comes up with a well-defined business strategy over a particular timeline. One of the key aims of this strategy is to manage cash flows – the net of operating expenses and revenues – by cutting costs and selling assets not important for the core business like properties or units. This is also followed by an increase in sales push to drive revenues at the promise of incentives. These cash inflows could then be reinvested in the company to meet costs.
Turnaround stocks often have cheap valuations – that is low PE or Price-to-Earnings and PB or Price-to-Book value ratios. The PE ratio is a measure of how much investors shell out for each rupee earned, while the PB ratio is the amount investors are paying for each rupee of the company’s assets excluding the brand value and goodwill. This is because the company, and therefore the stock, is undervalued by the market. However, sometimes, PE ratios can be high if the earnings are very poor, and PB ratios can be negative if the companies’ liabilities or debt exceed its assets.
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