The Turnaround Investment Strategy

Buying a mature company whose stock price, and business fundamentals, in recent years have deteriorated is a high risk strategy. We are speculating that either (1) The business will improve more than the market believes, (2) that the deterioration has been exagerrated by the market and that the remaining earning power is being undervalued (i.e. that we better understand the business economics of the company than the market in general). We have a preference for category 2, as here we don´t have to fight the old adage, "turnarounds often don´t turn". However, in this strategy downside risks may be larger than other investment categories. We may under estimate the loss of earning power from poor management, changing market structure or obsolescence of the companies products, services and skills. As a result, venturing into this area must result in a potentially very satisfying reward - we would expect to at least double our investment in the next 5 years (approx. 15% per annum). We currently have two turnaround investments in portfolios. A defense company and an "old technology" company. Neither have significant leverage, hence have the ability to survive a financial shock in the short term should funding become difficult (i.e. less general liquidity as well as problems from their negative market label at the moment). Turnarounds also have advantages. There stock price performance can be less correlated to the market as its fortunes are often more greatly influenced by internal changes rather than external changes (i.e. less influenced by the macro environment, especially if a non cyclical revenue generator). Turnaround strategies must be followed more closely than other investment categories, i.e. relative to an asset play. We must be confident we are not seeing more deterioration than we expected - that the earning power we envisioned is still there and producing, that any changes to capital allocation are adding to sales and cash flow in a satisfactory manner. As a result, for such companies we closely follow quarterly earnings and the general news flow.