Turnarounds and Value Investing
It's been great to take a few days off of work, a few days off of blogging! No doubt, fatigue sets in, ideas tend to get outworn or musty, and the bedraggled routine of everyday thinking needs to be revamped. Readers need a break from my mental meanderings as well!
I am very fortunate...I truly love my work largely because it is my own work. As Mark Twain observed, "Cursed is the man who has found some other man's work and cannot lose it." That's one of the best aspects of the investment management business, whether you are pursuing it professionally or for your personal gains...everyone can have their own style of investing. If it represents a discipline that you can formulate and follow, then it has a chance of success. Otherwise, investment management becomes random shots at stocks, a scattergun approach to the market.
One of my mentors used to counsel me, "If you don't know where you are going, any road will do."
Find a discipline that will work for you and that you can be comfortable with. It might not be value investing, the discipline that I follow...and that is perfectly okay! One of my former partners, though he described himself as a value investor, was really more of a technician. He would seek opportunities in cyclical stocks based on charts. His fundamental judgments in non-cyclical stocks were peculiar and rarely rationally based. At least, I couldn't find the rationale. Yet, time and time again, with his particular knowledge of the paper and forest products sector, he could find bargains largely based on charting. Bill of Absolutely No DooDahs has impressed me greatly with the uniqueness of his thinking that combines fundamentals with statistical probabilities and technical analysis...a very broadly based point of view.
This weekend, I've been asking myself. "Can a Buffetteer be involved in a turnaround stock?" If we take a pure Joel Greenblatt approach (of 'Little Book" fame), it seems the answer is no. Such companies will not meet the return on invested capital hurdle that Greenblatt requires, at least not for the most recent TTM period. Yet, when we examine some of the companies that Buffett has purchased, there are turnaround characteristics present...most recently Russell Corp. which has a return on capital of barely 2% for the TTM.
An excellent research piece by Jaison Blair of Rochdale Research which was recently published, clarifies what is needed to "Find Good Businesses When They Go on Sale."
- Reversion Toward the Mean- Is current profitability below historical levels? Does the company have a sustainable competitive advantage that is distorted by temporary factors? For example, in WalMart (WMT) have high energy prices permanently affected its target audience?
- Depressed Valuation Relative to Normalized Profitability- Plugging in numbers that assume some restoration of profitability, whether based on margins, or return on capital, should result in a bargain price. Evaluating what we know relating to historical performance, industry structure and margins, as well as management's plans should help us assess where profitability ought to be...and what the resultant valuation becomes. For example, many value investors (myself included) have positions in media stocks that look very cheap relative to historical norms. Westwood One (WON) sells at 10.7 times trailing earnings, an all-time low relative to its ten year history; it sells at book value, again unprecedently cheap; it sells at less than 9 times cash flow, agin, not seen in its prior history. But return on capital in the most recent year is down about 2% from its peak of four years ago...what is normalized profitability for this business?
- Conviction that the Situation is Temporary- Clearly, if we believe that an industry's fundamentals have undergone a permanent shift downward, historical numbers have no place in our analysis. Accept the reality and model this in your work. For example, I do not believe that terrestrial radio is finished as a business, nor do I believe that returns on invested capital will be permanently stuck at these levels.
- Does Management's Plan to Restore the Business Make Sense?- Is the plan sensible, and do we believe that management can execute based on historical performance and industry conditions?
- Financial Strength to Weather the Storm- Respect the downside. Is there sufficient balance sheet strength to survive a war, let alone a battle, or is there potential for resource conversion such as sales of assets or subsidiary businesses that could bolster the balance sheet if the turnaround falters? Is there evidence of debt being paid down or improvement in working capital management?
The absolute ideal investment is buying something that is great at a fair price. "Iscar" was such an investment for Berkshire. But, leave room in your thinking for the Russell's of this world...for the currently downtrodden, but only temporarily flawed business. Being involved in something that has a little hair on it can be highly profitable.
Importantly though, I do not believe that assessing a turnaround allows much flexibility in the above criteria. I think having just four of the five criteria met is not good enough! You really need all five. A depressed price relative to "Normal" profitability is great but if there is no plan to restore profitability from a credible management team, what have you got? The answer...a permanently depressed stock. As I like to say, "Presents excellent value, and likely to stay there." If there is no balance sheet to count on, tomorrow may never come.
Turnarounds can be tricky. They invariably take longer than you expect. Having too much exposure to a turnaround strategy will subject you to perhaps more risk than you anticipate despite having what at least superficially appears to be a diversified portfolio. Given the vagaries of markets and the short term sensitivity of many players, an ill-timed turnaround can play havoc with your results.
But don't exclude turnarounds from your investment strategy. Excellence is rarely priced cheaply. When it is, jump on it. Great companies which are fairly priced, provided they can maintain their competitive advantage and consequently, their "greatness" are where most of your portfolio should reside. Finally, a few turnaround candidates can provide outstanding returns when they work, and annoyance and disappointment as they "just sit there." Or worse. But the rewards more than compensate for the risk when the above criteria are followed.
Disclaimer: I, my family, and most clients have a current position in Berkshire Hathaway. I, my family, and most clients have a current position in Westwood One and are patiently awaiting the turnaround!