In his book One Up on Wall Street, Peter Lynch penned the following adage as one of the 12 silliest things people say about share prices, "If it has gone down this much already, it can't go much lower".
Many people fall into the trap of thinking this way when they invest in a troubled share, or try to determine when a troubled company is about to be turned around.
As I've said previously, troubled shares are out of favour with investors. The company has usually suffered such a huge decline in both profits and share price that investors can't wait to offload its shares.
Troubled shares remain one of the more risky, and certainly the most exciting, investments. However, there are a few pointers that you can follow to minimise the likelihood of making a bad decision.
Let's examine two great turnaround stories of the past decade.
Edgars is an example of a cyclical share (one that depends on the economic cycle, particularly interest rates and consumer spending) that hit hard times. In 1998, interest rates rose dramatically, and retailers started to feel the pinch as consumers tightened their belts.
Edgars had a few problems of its own. Those were the days when Minki had just started high school, and although brands such as Guess and Levi were gaining in popularity, they were not as ubiquitous as they are today. Clothing retailers such as Edgars made more profit on their own brands.
But the wave of brand consciousness was starting to sweep through the malls of South Africa, and house brands were losing ground.
As if that was not bad enough, aggressive marketing by the likes of Mr Price (remember those jeans for R59.95?) hit Edgars at the lower-price end of the market. Even regular "red dot" sales and discounting did not help; in fact, they probably harmed the Edgars brand in the short term.
Retailers in general lagged behind the rest of the market in 1998, but Edgars dramatically under-performed even in its own sector, dropping from R80 to R17.50 - a decline of almost 80 percent.
Edgars acted by making a few changes to top management and by rationalising its store space, so that its existing space worked harder.
The share rebounded to around R70 by the end of 1999, dropped back again to the low 20s and then surged to its current level of nearly R300 as the economy entered the lower interest rate environment.
Edgars is a classic example of a great turnaround: it addressed some internal problems and benefited from improved trading conditions.
The share price's rocky ride, from its 1996 high, involved a loss of 70 percent, followed by a gain of 300 percent, another drop of 60 percent and then a return of 800 percent over the next few years.
It is worth noting that investors who bought at the 1996 peak of R160 had to wait nine years for their shares to return to that level.
Another good example of a successful turnaround is shipping company Grindrod. Until 1996, Grindrod shares were regarded as steady growers. The company showed a loss in 1999 when world shipping slowed down. Interestingly, however, its share price had been declining since 1996, dropping 75 percent in the three years to 1999.
The company made some management changes, sold its poorer performing ships and started building a better fleet. At the same time, world trade picked up again and shipping improved dramatically. Grindrod's share price rebounded, apart from a brief rest in 2002/3, from a low of R1 in 1999 to its current level of R47 - an increase of 2 800 percent.
What are some of the things you should consider before you invest in a troubled share that you hope will become a successful turnaround? My advice is as follows:
- A company's share price may start falling long before news about how bad things are in the company becomes general knowledge. Make sure you keep up to date with what is happening in the company and its operating environment. A lower share price is not always an opportunity to buy.
- Take note of changes to management. Such changes do not necessarily mean that the previous management was to blame for what went wrong, but a fresh management team can help a company to turn around.
- Look out for decisive action from management. It must be clear that management has the incentive and the authority from the shareholders to do what is needed to turn the company around.
- Make sure the financial structure is addressed so that the com-pany can weather the bad times. After all, you, the investor, need a margin of safety. Look for recapitalisation, the repayment of debt, and the closure, reorganisation or sale of divisions that consume cash flow.
- Try to figure out what kind of share you will own once the com-pany has been turned around. In the above examples, an extended period of good business conditions, either after or during the time the company addressed its problems, ensured that sound returns were sustained over a longer period. However, many shares revert to the type of shares they were before the company got into trouble - for example, cyclical or slow growing.
- Turnarounds that produce the best returns usually experience internal and external improvements - in other words, management action and a better operating environment. The returns from these companies can be huge, even if you don't buy when the share price is rock-bottom. You will, of course, make super returns if you buy when uncertainty about the company is at its peak and the share price is at its lowest ebb.
- As with most successful investing, an element of good fortune (let's not call it luck) - both for the investor and for the company's management - has a role to play in successful turnaround investments.