According to Putnam, most investors chase the same stocks which are followed by hundreds of highly trained analysts and so it is hard to outperform.
So he advises investors to seek out unloved, down-and-out turnaround situations as when these stocks eventually do come back, they can soar as investors pile into them.
“Our approach is simple. We avoid the “blue chips” and “hot” stocks that most investors are stampeding into. Instead, we search out companies that have had some problems and are temporarily out-of-favor, but are in the process of turning around. These stocks seem like laggards when we first identify them, but as the turnaround becomes more evident, Wall Street will jump into the stock and push the price up – often dramatically,” he wrote in his Turnaround Investment Letter.
Who is George Putnam III?
Putnam is President of New Generation Advisors, LLC, an investment adviser that focuses on distressed securities. He is also Chairman of New Generation Research, Inc., which publishes information about bankruptcies and troubled companies. He founded both companies in the late 1980’s.
Putnam came up with tips and principles which may help investors spot turnaround stocks for solid returns. Let’s look at these tips.
1. Be willing to go against the crowd.
Putnam says by their nature, turnaround stocks are unpopular and that’s why they have so much profit potential.
“If you wait until they are popular again, you will miss most of the gains. For example, back in 1993 when IBM dropped down to about 10 (adjusted for splits) most analysts called it a dinosaur. Then, when the stock got back up to 100 a few years later, everyone loved it again,” he says.
2. Previous stock prices are irrelevant
According to Putnam, too often investors fall into the trap of saying this stock used to trade at 50, and now it is at 5 – it must be a bargain.
“A stock is only a bargain if it is currently undervalued, and that depends solely on what the stock is actually worth today – not what investors thought it was worth last month or last year,” he says.
3. Look for a solid core business.
Putnam says investors should look for a company that has a solid foundation on which to base its recovery.
“If the business was based on a fad or an obsolete technology, the stock is not likely to rebound. But if the company’s basic business remains sound, there is a better chance the stock will bounce back,” he says.
4. Evaluate management’s ability to turn things around.
Putnam says evaluating management is important for any stock, but it is particularly important in a turnaround situation.
“In many cases, the management that got the company into trouble isn’t likely to be able to get it out of trouble again. Therefore, a change in top management can be a good sign,” he says.
5. Look for someone else to do the heavy lifting.
Putnam says the presence of a big investor who is willing to get involved and shake up the company can be a good thing but investors should make sure that the big investor owns the same security that they do.
“Sometimes the big investors own bonds or preferred stock, in which case they may not care what happens to the holders of the common stock,” he says.
6. Check the debt.
Putnam says investors should check the debt of the company as a heavy debt burden is often part of the reason that the company is in trouble and a high level of debt significantly reduces the company’s flexibility in making necessary changes to its business.
“If the company must restructure, the debt has to be taken care of before stockholders get any value,” he says.
7. Be patient.
Putnam says turnarounds take time so investors need to be patient.
“Even if the company has turned around, it may take still longer for investors to recognize the turnaround and to get comfortable with the stock again,” he says.
8. Diversify.
Putnam says diversification is important in any type of investing, but it is particularly important in turnaround investing.
“Turnaround situations always are affected by a large number of variables, and no matter how much research you do, you will always have some situations that don’t work out the way you expect them to,” he says.
According to Putnam, the best way to minimize risk in turnarounds is to spread money over a large number of different stocks which increases chances of having some big winners to offset inevitable losers.
(Disclaimer: This article is based on George Putnam III’s Turnaround Investment Letter )
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