Turnaround stocks represent companies that are on the verge of a possible u-turn, or a revival of their fortunes. Due to their inherent volatile nature, they are pure contrarian plays and are therefore not ideal for the fainthearted. While they lure investors with a possibility of monumental returns in the long run, they can also turn sour — as in the case of investors who bought into the US Airways Group Inc (NYSE:LCC)’ turnaround story in 2003 and ended up with enormous losses when the company filed for another bankruptcy just 12 months later.
These stocks are generally difficult to judge based on conventional metrics, such as price-to-earnings ratio (P/E) and PEG ratio, since either they are not making any profits or have just started eking out some income as their shares rally – which often results in a negative or an unusually large P/E ratio.
I believe that as a general rule, investors shouldn’t bet on a company’s turnaround which:
a) has a high debt-to-equity ratio, i.e. anything above 70%;
b) is operating in a dying industry
Companies that have reasonable debt levels, have delivered a history of solid performance in their ‘golden years’, and are operating in an industry with huge potential are a much safer and attractive bet. The three companies mentioned below could represent significant upside but potential investors should note that while investing in markets is risky, investing in turnaround stocks is even riskier.
Bright outlook but heavy on debt
One such company eying a turnaround is the mortgage insurer MGIC Investment Corp. (NYSE:MTG) following its disastrous run during the global recession. In the last 12 months, the company has generated a loss per share $4.68 with a disappointing return on equity of -102.7%. However, its future is looking brighter due to improvements in the housing market, better quality of credit of its new business and an increase in its market share from the FHA.
In short, the company is one of the few survivors of the housing crisis and is in a good position to capitalize on the sector’s recovery. Despite the negative numbers mentioned above, the stock has been up an astounding 192% this year. Moreover, its most recent results announced on July 24 have also given more confidence to investors.
MGIC Investment Corp. (NYSE:MTG) surprised the market by reporting an operating profit of $0.04 per share, as opposed to the market’s expectations of a loss of $0.16 per share. The current results are the first profit since Q2 2010 and have come due to a fall in new notices and a lower claim rate of early stage delinquencies.
However, despite the rally and a bright outlook, I would rate MGIC Investment Corp. (NYSE:MTG) a ‘hold’ rather than a ‘buy’ at the current post-earnings-release price levels. The company is operating under a heavy debt load with a total debt-to-equity ratio of 193%, far above my target of 70%. This when its competitor Radian Group Inc (NYSE:RDN) has a debt-to-equity ratio of 113%, and even that is considerably above the sector’s average of 52.8%.
Struggling and undervalued former smartphone king
Perhaps no other company is more desperate for a turnaround of its fortune than the Canadian smartphone maker BlackBerry Ltd (NASDAQ:BBRY). It doesn’t have any trailing or forward P/E ratio since it has generated, and is expected to incur further negative EPS. Its recent earnings release was horrendous but the treatment which it got, a 30% sell-off, was certainly an overreaction. Its stock, which now trades at $8.98, is extremely cheap by any measure and represents more than a 50% discount to its book value.