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How to Trade a Turnaround Situation

January 12, 2015



Another form of earnings acceleration to look for is during a turnaround situation. A stock had been doing well but then fell on hard times. During the difficult period, the company probably had some negative earnings surprises, for example, growing at a slower rate than expected, growing by only a single digit percentage, or perhaps reporting negative results. In some quarters, earnings may have declined compared with the year-ago period.

 

Then, all of a sudden, earnings growth explodes. The company reports quarterly earnings that are up 50 percent from the prior-year period, and the next quarter it shows a greater than 100 percent year-over-year gain; in the subsequentquarter, results are up 150 percent. Amplifying this performance are the easy comparisons from the prior year when the company was struggling. Now, as things start to turn around, not only is the company able to post higher earnings, the gains on a percentage basis look dramatically better.

 

With turnaround situations, investors should insist that the current earnings be very strong (+100 percent or better in the most recent one or two quarters). If the previous results were dismal, the company should be doing significantly better percentagewise in light of easy comparisons. You could also insist that earnings and margins be at or close to a new high for added confirmation that the company is back on track.

 

In some cases, you can spot turnarounds and earnings acceleration by comparing the current annual growth rate or current quarterly results with the three- or five-year growth rate. A company that has been growing 12 percent a year and suddenly starts to show growth of 40 percent and then 100 percent could be a hot prospect.

 

 

Look for a Breakout Year

 

You can go back two to four years or more to a record year and see if current earnings are breaking out above the previous trend. It can be a fairly significant event if earnings suddenly break out to the upside from a range that was established over several years. Finally, check the upcoming one or two quarters as well as the next fiscal year to see if earnings acceleration is expected to continue.

 

Deceleration Is a Red Flag

 

A company can be doing great with high-double-digit percentage growth and then “deteriorate” to mid-double-digit growth. For another company, growing by 20 or 30 percent may be a big improvement. However, for a company that had been growing at upward of 50 to 60 percent or more, a growth rate of 20 to 30 percent would be a material deterioration.

 

Consider what happened with Dell Computer, which from 1995 to 1997 had grown its earnings per share at 80 percent annually and then declined to around 65 percent in 1998 and 28 percent in 1999. Although this was still decent growth, it was a material change and marked the end of the tremendous move in Dell’s stock price. The stock peaked in 2000. Ten years later Dell’s stock price was considerably lower, down more than 80 percent from its high.

 

In summary, institutions like to see the following:

 

• Upside earnings surprises

• Accelerating earnings per share (EPS) and revenues

• Expanding margins

• EPS breakout

• Signs that acceleration will continue

 

 

Beware Profitability via Cost Cutting

 

With an understanding of the three major drivers of earnings (higher volume, higher prices, and lower costs), it pays to be cautious if a company is delivering only on cutting costs. A company can increase profits by cutting jobs, closing plants, or shedding its losing operations. However, these measures have a limited life span.

 

Eventually, a company will have to do something else to grow its business and increase its top line. Therefore, check the story behind earnings growth. Make sure that it’s not because of a one-time event, because sales jumped as a result of some extraordinary gain, or because profits improved only as a result of cost cutting.

 

Companies with good potential for stock price appreciation show evidence that earnings growth is sustainable and will continue over some length of time. The ideal situation is when a company has higher sales volume with new and current products in new and existing markets as well as higher prices and reduced costs. That’s a winning combination.

 

In general, the best growth candidates have the ability to expand, introduce new products and services, and enter new markets. They have the power to raise prices, and they can improve productivity and cut costs. The combination of revenue acceleration and margin expansion will have a dramatic effect on the bottom line.

 

The worst situation is when a company has limited pricing power, its business is capital-intensive, margins are low or under pressure, and it’s faced with heavy regulation, intense competition, or both. 

 

When strong earnings are reported, check the story behind the results to make sure the good news is not due to a one-time event but is the product of conditions that probably will continue. Your questions should include the following:

 

• Are there any new products or services or positive industry changes?

• What is the company doing to increase revenue and expand margins?

• What is the company doing to decrease costs and increase productivity?

 

 

This blog is an excerpt from Trade Like A Stock Market Wizard; How to Achieve Superperformance in Stocks (McGraw Hill 2012)



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