Corporate Turnarounds. 2004-12-16
Spot a corporate turnaround at the right time and it can be a big winner for your portfolio. When a stock drops 80% in price, it's like buying one share of stock and getting four free.
In 1982, Werner DeBondt and Richard Thaler, both university professors, did an experiment. They analyzed the 35 best performing and the 35 worst performing stocks from 1932 to 1977. While the broad market produced gains of 12.2%, the professors found that the best performing stocks actually lost 4.3%. But, the worst performing stocks actually showed big profits. On average they produced 18% gains.
The two men described the Rebounding of poorly performing stocks as a "reversion to the mean" which many traders today see as a law of nature.
When a company's stock drops 80% it usually indicates the company has serious problems. This big drop in stock price often comes when companies, that were overvalued, announce revenue shortfalls, tax scandals, or large debts.
This 80% drop isn't just a signal of bad media or unachieved expectations... it's usually closely tied to uncertainty. No one knows what will happen next.
Of course, there is no way for you to know what's next. So, to invest in a stock that's dropped 80%, you have to know that it's worth much more than its current price. There are many ways to perform this valuation. But, you can actually start researching after the company's stock prices tumbles 80%. That's how you'll figure out if the company can turn itself around. That's what's most important. Because a turnaround often brings a rebound in stock price.
In 2002, the shares of a small Irish pharmaceutical, named Elan, fell from over $40 down to $2. The value of its investments decreased by over 90%, the patents on its core drug were about to expire, and there were ongoing investigations from the SEC. Elan was at risk of bankruptcy.
But, Elan CEO Garo Armen had a plan. He would sell off non-core assets to repay debts and he also had two new drugs about to complete clinical trials. This would mean billions in added revenue for Elan.
18 months later, Elan was trading for $25 per share. That's a gain of 900%.
Had Elan not dropped so low, such gains may not have been possible. Not to mention, we may never have found it for our subscribers. The fact that its shares had descended so low meant most investors never even saw the potential.
After an 80% drop, if a stock recovers one-third of the ground it lost, it'll double your money. That's better than you'll ever hope to do in the broad market big indexes (SP500, Dow30, FTSE100, etc.)
Do you remember Tyco? It's a huge conglomerate that fell victim to the excesses of the late 1990s. Back then, Tyco was one of the most recommended stocks in the world. It was very actively traded. But Tyco's executives spent millions they shouldn't have. Dennis Kozlowski, the company's former CEO, was an amazing corporate genius. But he threw lavish parties, spent millions on art and real estate.
The stock fell from over $50 to $10, by July 2002 it was less than $7.
The media gave excessive coverage to what they thought was Tyco's implosion.
But Tyco was a real business, with real earnings. Nobody in the mainstream media wrote about the turnaround of Tyco.
But Bill Miller, Legg Mason's famed Value Trust mutual fund manager was busy buying 82 million shares of Tyco. An enormous position.
How did Miller know it was time to buy?
1. A competent new CEO was appointed.
2. Tyco had cash available to finance a turnaround.
3. The company put together a comprehensive and realistic turnaround plan. This regained the confidence of Wall St.
Today Tyco trades for over $35, up 320% from their low!