Turnarounds: How to find value shares that are bouncing back
Back in 2012, shares in the media company Trinity Mirror looked surprisingly cheap given the amount of cash the business was throwing off. Despite its outdated business model, the newspaper publisher was still managing to juggle a high level of debt and a troublesome pension deficit. But what was more concerning was its seeming inability to adapt to a digital age. Investors were nervous about how long the cash would keep flowing. On top of that, there were worries that it would get sucked into the industry’s phone-hacking scandal and end up facing stiff penalties or worse. Only those with a cast iron constitution were prepared to buy the shares. Many believed it was a value trap, even at such an apparently cheap price.
But despite the negative sentiment, shares in Trinity Mirror took off and it became a multi-bagger over the next two years. Opinions are still divided on whether it’s a business (now known as Reach) with a sustainable future. But what isn’t in doubt is that Trinity Mirror was a classic Turnaround play. It was in a class of shares that rebound in price from what can sometimes look like terminal decline.
In the Stockopedia taxonomy of stock market winners, Turnarounds are the stocks that are both attractively valued and have strengthening price and earnings momentum. Value & Momentum have an intriguing relationship because as powerful individual factors that drive returns, they tend to work well at different times. Value has been shown to work best over long periods, but is particularly potent when markets are in recovery mode. By contrast, Momentum is much more time-limited and works most effectively during bullish, trending phases. For these reasons, the two factors are often used together to ‘smooth’ returns in portfolios over time. But when you get both value and momentum working together simultaneously in a single stock, it can be a great sign of a turnaround in progress.
The profile of a Turnaround
To understand the nature of Turnarounds, it’s useful to put them in context. In this article we’ve looked at how using Value as a factor on its own can lead to an uncomfortable exposure to shares that that might keep falling in price. With no other redeeming features, a stock that’s just cheap can end up being a dreaded Value Trap.
By comparison, stocks with an attractive valuation and good quality (but weak price strength) have the profile of Contrarian shares. These are the shares that may have hit temporary setbacks or are momentarily out of favour. But their high quality makes them statistically more likely to recover.
The third member of this Value ‘triumvirate’ are Turnarounds. They may not have the moat-like business strength or financial quality of Contrarians, but they may have turned the corner to recovery. While still cheap, brokers may start forecasting an improvement in fundamentals ahead of the reality, ratcheting up their earnings forecasts and kicking off a new share price trend.
One of the best authorities on Turnarounds is Peter Lynch, the one-time star fund manager at Fidelity Investments. In his book One Up on Wall Street, he paints a picture of them being stricken businesses, but insists that shares in successful Turnarounds can recover quickly:
Turnaround candidates have been battered, depressed and often can barely drag themselves into Chapter 11 [bankruptcy]. These aren’t slow growers; these are no growers. These aren’t cyclicals that rebound; these are potential fatalities…
In addition, Lynch reckons that there are several types of turnarounds:
Interestingly, the obvious candidates for Lynch’s first category - bail-us-out-or-else - are UK banks. Shares in the likes of RBS and Lloyds crashed ahead of their bail-out in 2008. But it remains to been seen when or whether investors who ventured back into those shares in the subsequent years will be repaid. By contrast, the share action at Trinity Mirror - swinging from 550p to 25p and back as high as 229p in seven years - echoes the sentiment of Lynch’s second category: who-would-have-thunk-it?
As for the others? The Macondo oil disaster trashed shares in oil giant BP in 2010, and captures what Lynch mildly understates as the little-problem-we-didn’t-anticipate. Meanwhile, Harriet Green navigated travel group Thomas Cook away from imminent disaster in 2013 in an episode that you could lever into his perfectly-good-company-inside-a-bankrupt-company. And finally, restructuring-to-maximise-shareholder-value is perhaps amply reflected in any number of mining stocks that have come under huge pressure to shore up their balance sheets in the face of weak commodity prices.
From a historical perspective, the argument in favour of blending Value and Momentum has probably been best put by US fund manager, James O’Shaughnessy. He’s spent many years - and devised several strategies - based on statistical patterns that emerge from the vast S&P Compustat database. He’s documented these findings in various editions of his book What Works on Wall Street. More recently he has shown how looking for stocks that look cheap against a combination, or composite, of several value ratios, together with improving price strength, is the basis for “the best performing strategy since 1963”. O’Shaughnessy calls this Trending Value.
But O’Shaughnessy is by no means the only one to have wedded Value and Momentum to get stunning results. Strategies driven by academic research have been a major reason why this blend of factors is used by some of the most forward thinking fund managers in the world.
How the experts find Turnarounds
One influential figure in this debate is Josef Lakonishok. As a finance academic turned fund manager, he spent years studying investor behaviour and the drivers of long term market returns. He and his colleagues concluded that investors typically rely too much on the past to make predictions about the future, and frequently pay too high a price for the shares that they buy.
As a result, Lakonishok’s preferred tactic was to identify well-priced shares at the moment the market is starting to notice them. He found that whatever your definition of ‘cheap’ is, value stocks consistently outperform glamour stocks by wide margins. So he suggested using ratios like price-to-book, price-to-earnings, price-to-cash flow and price-to-sales to find shares that look cheap against their sector average. He also wanted to see 6-months of positive momentum and stocks that had beaten expectations or were having their earnings forecasts upgraded.
Another way of applying Momentum to a Value strategy is to think about ‘fundamental’ momentum. In other words, a track record of improving financial health. In 2000, Stanford accounting professor Joseph Piotroski showed a way of doing this with a nine-point accounting checklist called the ‘F-Score’. That checklist is now used by some big institutional investors as a measure of a company’s quality. But in his original work, Piotroski specifically used it as a means of finding potential Turnarounds among the cheapest stocks in the market. His studies found that those with the highest financial strength often went on to outperform - on average by 7.5% annually over a 20 year backtest.
Where Turnarounds go next
One of the biggest areas of concern in the hunt for Turnaround plays is that the Momentum ebbs away. Value shares that are on the mend can be more susceptible than others to a sudden change of fortune that causes investors to run for the exit. In the absence of strong or improving quality signals, investors could be left holding a value stock that simply drifts if the momentum collapses.
It’s also worth noting that a Turnaround can take years to get going, but then unfold very quickly. Shares in greeting card distributor International Greetings collapsed from more than 400p to less than 20p through 2007 and 2008. While the price did rise in later years, it took until 2015 for the momentum to carry the price back through 100p and beyond.
Crucially, what International Greetings showed was how a typical Turnaround profile can quickly morph into that of a High Flyer. Smart investors like the fund manager Gervais Williams had cottoned onto the turnaround story early, but as its momentum accelerated and its financial strength improved in early 2015, International Greetings no longer looked obviously cheap. Instead, it carried the hallmarks of a high quality, high momentum share - which has been the classic profile of some of the UK’s best performing stocks.
Lessons from Turnarounds
To varying degrees, the combination of attractive valuation and positive price strength can be found in the strategies of some of the world’s best known and most successful investors. Academic research shows that it’s an effective way of spotting beaten down shares that might be recovering. And our brief analysis using the StockRanks shows that it has worked very effectively over the past three years.
But it’s undeniable that in the absence of business and financial quality, investing in Turnarounds can be risky and unpalatable. After all, the strategy means digging around among cheap shares that may have suffered major upsets and face unpredictable futures. But when they work successfully, they can reward investors with sudden and spectacular gains.