Dumpster Diving For Treasure

“Don’t catch a falling knife” is a famous phrase that cautions investors against buying the dip on a stock that is consistently falling in price.

The idea is that by avoiding out of favor stocks, investors can prevent major portfolio losses and deploy capital into winners instead.

It’s a rule followed by many momentum style investors, and there’s serious merit to this approach.

However, like most “rules” in investing, there are times to follow it and times to break it.

Some of the all time greatest investments ever made were in companies that were left for dead by the market that had a phoenix-like rise from the ashes.

Think Amazon after the dotcom bust, Apple after the return of Steve Jobs, Netflix as they shifted away from DVDs, and AMD after Lisa Su took over.

All of these stocks ended up producing incredible returns for investors who had the stomach to buy near the lows and hold on for at least a few years of recovery.

Impressive turnarounds aren’t unique to the tech sector either.

Stocks like American Tower (AMT), Tractor Supply (TSCO), Dominos Pizza (DPZ), Abercrombie & Fitch (ANF), and Build-A-Bear (BBW) went from near death to generating stellar returns.

Who would have thought a mall-based retailer of stuffed animals, down 90% in three years, could deliver a 20X return over the following five years?

Finding Treasure Among The Junk 🗑️

The problem with “comeback” companies (and their stocks) is that turnarounds can take a long time and have a high rate of failure.

In fact, more turnarounds fail than succeed.

We’ve seen failed turnarounds recently with Blue Apron, Spirit Airlines, Bed Bath & Beyond, Blackberry, JC Penney, and WeWork.

Betting on every potential turnaround is a recipe for disaster that could permanently crush a portfolio.

Yet the rewards for finding the select few that succeed can be life changing.

So how do we filter out the likely value traps and focus on the higher probability potential comebacks?

Ignore Likely Zeros

Investors have a higher probability of getting wiped out quickly in sectors like banks and manufacturing.

High levels of debt on the balance sheet and unprofitability also create huge barriers in turnarounds.

This gives us some sectors and financial profiles to avoid.

Proper Position Sizing

Sizing turnaround plays smaller in a portfolio, especially before there’s confirmation of it working, is also key to limiting losses.

We like to keep the total exposure to turnarounds below 20% of the total active portfolio.

This limits the damage if and when we are wrong about an asset’s recovery.

Another way to commit less capital is by utilizing call options rather than stock, but the risk reward profile is different (higher risk higher reward) and liquidity isn’t always available.

Wait For Chart Confirmation

Another method for increasing chances of a successful turnaround play is to wait for an entry on the stock until AFTER price action has confirmed something is working.

This could mean the chart has reclaimed key moving averages and/or formed a bottoming pattern.

While an investor won’t get the lowest price, it can still mean strong returns if the turnaround continues.

Even if an investor did buy stock near the lows, sizing up the position size as the stock confirms fundamental improvement is also an option.

Hidden Assets & Overlooked Growth Drivers

A nice trait to find in a turnaround company is when they have an asset that could be monetized (such as a real estate holding) which reduces the possible financial downside.

Often the market will not be giving the company credit in the valuation.

Similarly, the market may be giving an unloved company no credit for possible future growth drivers.

Two years after Steve Jobs announced the iPhone, Apple’s stock was still below $3 per share for example (today it trades at $260):

Usually there are fewer investors paying attention to companies whose stocks are weak.

But powerful returns can be had if you see potential for growth before the market discovers it.

A Fresh Turnaround Idea 💡

This brings us to a timely stock idea that is both unloved and possibly on the verge of a big move higher.

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