Turnaround Option Stock Investing and Howard Marks of Oaktree Capital
I recently read an article by Jason Zweig (here) that suggested investors moving into deep value stock investments for the first time will likely burnout and lose money. This may seem strange to the average investor considering the recent performance of small cap value stocks. However, without a proper introduction into the emotions of deep value investing Mr. Zweigs prediction is correct.
For two decades I have been investing in what I call turnaround option stocks. These are stocks that have typically suffered a price decline greater than 70%. In most cases the companies are loosing money or breaking even. This is what creates deep value opportunities. Typically the companies have a rock solid balance sheet or are very leveraged. If it’s leveraged, the equity cap is 25% to 50% of the debt outstanding. Thus the term option stock.
I look at numerous option stock candidates a year and choose a handful to invest in. I apply my experience from having operated both successful and unsuccessful turnarounds. I look for management teams that will implement what I call “The Turnaround Prescription”. A detailed and strategic plan to accomplish substantially all of the following:
1. Increase gross margins while simultaneously reducing operating expenses to a targeted operating margin
2. Introduction of new or improved products or services to core customers
3. Immediate improvements in working capital turnover
4. Focused on implementing new standards of accountability and employee involvement
I also bring my abilities as a CPA and CFE to pick apart the financial statements to determine the staying power of the company.
I want you to know that despite this experience and knowledge there are always uncertainties. Turnaround option stock investing is not always classic Graham and Dodd where you get a dollar for 50 cents. In some cases your capital may be lost completely or you may lose 50% if the company cannot complete a turnaround or survive an industry downturn. However, if it works you earn 3 to 10x your investment.
I am fond of Howard Marks explanation for gauging the odds of a turnaround. He incorporates “ second level thinking”. He looks at the possible outcomes that can happen and assigns a probability to each occurring. I call it a 3D examination of how a company’s balance sheet, cash flow, operating leverage and management mix under various scenarios. Will a company be able to survive at the peak of pricing pressure? Where are we in the cycle or pendulum of the cycle that the company participates in? When we view the odds in our favor of a 3 to 5 bagger we make the investment despite a small possibility we may loose our entire investment. A portfolio of similar option stocks allows an investor to spread the risks.
The next hurdle for deep value turnaround investing is the waiting. In most cases the investment period typically takes longer than originally planned. The results sequentially also prove very volatile as circumstances arise you would never anticipate. It can be easy for investors who are not thoroughly familiar with a management teams turnaround plan to throw in the towel when expected results don’t meet expectations in the short term. The most frustrating event is watching the share price decline when consensus earnings were not met but good operational progress has occurred. Investors can’t see the progress occurring in operations and marketing in an income statement. However, this is the price for a 3 to 5 bagger return.
This battle is well documented in Howard Marks book “ The Most Important Thing”. He believes that Psychology is probably the most important attribute for a Turnaround Investor, I agree.
I am currently invested in a turnaround option stock that has risen and reversed from 4 to 8 three times over a two-year period. The company’s sequential earnings are erratic but it appears the important characteristics of cash flow and working capital ratios are improving while operating in a very difficult environment. The balance sheet is leveraged but great progress is continuing operationally. I continue to hold through the extreme volatility for what I believe will be a 3 bagger.
An investor considering deep value investing must make sure they have not only a temperament for volatility but can perform the 3D financial and operational examination of a company to determine the odds for a turnaround success. This will allow an investor to hold on when volatility rises.
