Turnarounds as a Type of Special Situation Investment

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Turnarounds as a Type of Special Situation Investment

As far back as I can remember, I put an outsized focus on special situation stock investing because I knew that in some instances, the rewards I could reap from certain outlier circumstances would be worth the research. And it just made investing more fun than a standard value investing approach.

I originally used a written list that laid out a framework for what I was looking for on a daily basis across press releases and Security Exchange Commission (SEC) filings at SEC.gov. Yes, written… Remember I am old!

Later, when I started Geoinvesting, each member of my team had a physical printout of the list so it could be readily visible as an outsized 8.5 x 11 inch post-it note.

Regardless of what position one held at Geo, I made sure that each team member was exposed to the our research process to some degree, with the aid of checklists, even if the list became pinned underneath a paperweight, taped to one of the many whiteboards I had floating on each wall when we used to work in “offices”, or handed back and forth between my colleagues if one went missing prior to a new printout.

Among a slew of other things, we looked for spinoffs, special dividends, activist activity, tender offers, reverse splits and uplists, share repurchase programs, Special Purpose Acquisition Activity (SPAC) activity, mergers and acquisitions, indications that a flip to profitability was in the cards, debt restructuring and chapter 11 bankruptcies, the last 4 of which gave us an indication that a turnaround was possible if measures were put in place to increase profitability or rectify certain flailing aspects of the business.

Now and again, we harp on the utility of focusing on the various special situations, but lately it’s been about turnarounds. In mid-2021, Jan Svenda, one of my analysts at MS Microcaps, ran a few screens that illustrated how filtering specifically for companies on various fundamental levels could produce a list of turnaround candidates. Of course, each one would have to be looked at 1 by 1, but it’s a start.

As it was pointed out before digging into Jan’s first example, generally speaking, there are obvious items, or a combination thereof, that you can screen for to produce these lists.

1. GAAP Loss combined with turn to profitability on a non-GAAP basis.
2. Losses combined with clear improvement in gross margin
3. Losses combined with flattening of operating expenses (OPEX)
4. Unimpressive revenue growth, however higher margin revenue mix on the lower revenue base.

Point 2 above produced 99 stocks at the time. A more granular combination produced 19 results, and a third set of criteria gave us 55.

So the real question here is, what do we do with these stocks once we have identified them?

One path that makes sense is to check for any kinds of actions that have been touched upon by the company, either through press releases or conference call transcripts, that are intended to mitigate operational shortcomings.  

And then, try to see what inning of a turnaround they might be in, in hopes that you might catch the company in the very early phase of a new growth cycle (provided that the valuation of the stock is reasonable).

Most press release services allow you to filter by categories that you can follow through tapping into feeds set up with your email or favorite RSS reader. 

Another major scenario would be to see if any activist investors are getting involved, or the likes of individuals with purposes similar to the ones we spoke of last week – turnaround specialists.

As we pointed out, there are:

“…a number of reasons why a company can be distressed and needs to turn its business around. poor financial performance, operational inefficiencies, a weak balance sheet, a lack of market penetration, and stagnant growth are some common offenders that businesses need to overcome to spark growth and eventual success. It takes good management, and in some cases new management, to recognize the solutions and act.”

The specialists, alternatively referred to as activists in some instances, or even corporate raiders, may seek to benefit by seizing a majority control of company operations and dictating how some of the facets of the business should be run. 

However, even activists that take a non-controlling investment in a target company can influence change if the shareholder base begins to connect with their message, especially when management does not own a good deal of the stock. 

We are not bashful in saying that we too like to benefit from these actions. It’s only natural that the byproduct of the actions of others would benefit those downstream…namely the shareholders. If the stock price recovers, it is a win for everyone.

Situations Where Outside Entities Might Get Involved:

• Chapter 11: One common type of special situation, as mentioned above, is that of Chapter 11 bankruptcy, a legal process that allows companies to restructure their debt, negotiate with creditors, and emerge with a new financial footing. The process is complex, and it requires expertise in areas such as corporate finance, accounting, and legal affairs. 
• Distressed Debt: Refers to bonds or other financial instruments issued by companies that are experiencing financial distress. These securities often trade at a discount because of the perceived risk of default. Distressed debt investors specialize in buying these securities and working with the company to turn around its operations. 
• Mergers and Acquisitions Candidates: Companies may seek to merge with or acquire another company for strategic reasons, but the process can be complex and challenging. Specialists with expertise in M&A can help companies navigate the process, conduct due diligence, and negotiate favorable terms for the deal.

To reiterate some of the details of special situation strategies we looked into, below is a small synopsis of a few. These are usually investment approaches that involve identifying and investing in companies that are undergoing a significant change or event that creates an opportunity for an investor to profit. 

1. Merger Arbitrage: This strategy involves investing in companies that are involved in mergers or acquisitions and aiming to profit from the price discrepancy that may occur during the process.
2. Distressed Debt: This strategy involves investing in the debt of companies that are in financial distress, with the aim of generating returns through restructuring or recovery of the company’s assets.
3. Spinoffs: This strategy involves investing in companies that have recently spun off a subsidiary or division, with the aim of benefiting from the company’s increased focus and potential growth opportunities.
4. Restructurings: This strategy involves investing in companies that are undergoing significant restructuring, such as divestitures, cost-cutting measures, or changes in management.
5. Bankruptcies: This strategy involves investing in the equity or debt of companies that have filed for bankruptcy or are in the process of reorganizing, with the aim of profiting from the company’s eventual recovery or liquidation.
6. Activism: This strategy involves taking an active role in a company’s management or operations to improve shareholder value, often through the use of shareholder proposals, proxy fights, or other means of exerting influence.
   
7. Special dividends or share buybacks: This strategy involves investing in companies that are distributing a special dividend or buying back shares, with the aim of benefiting from the resulting increase in shareholder value.

The current market environment is helping us key in on turnarounds, so keeping an eye out for when these strategies are applicable is quite helpful when considering a special situation for our Model Portfolios.

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