This is the last in a short series of blog posts covering my stock screen and investment strategy updates for 2019 and beyond.
Here’s a list of the other posts in this series:
- Why I’ll be looking at reported earnings instead of adjusted earnings from now on
- Why I’m measuring capital employed growth instead of earnings growth
- Companies with thin profit margins often make bad investments
- Factoring in the risk of excessive corporate debt
This post focuses on the lessons I’ve learned from investing in turnarounds and recovery stocks as well as corporate transformations.
Turnarounds seldom turn
Both our operating and investment experience cause us to conclude that ‘turnarounds’ seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.
Warren Buffett, 1979 Letter to Shareholders
“Turnarounds seldom turn” is the mantra of quality investors who insist that it’s better to buy a wonderful company at a fair price than a fair company at a wonderful price.
On the other hand, successful deep value investors (such as Warren Buffett pre-1970) will buy as many failed turnarounds as they can get their hands on, as long as the balance sheet and price are attractive enough.
Historically I’ve been closer to the deep value end of the spectrum, which isn’t a complete surprise because I started my stock picking career as a deep value investor back in 2007.
My default position to date has been that I’ll invest in a turnaround or recovery situation as long as the numbers stack up; i.e. if the company’s historic growth rate, growth quality, profitability, debt levels and valuation are acceptable.
Sometimes this has worked out well and sometimes it hasn’t. After eight years and quite a few investments, I feel like I have enough experience to at least voice my opinion.
Recovery, fitness and fatigue
No, this hasn’t turned into fitness blog. I’m talking about fitness and fatigue from the point of view of a recovering business, and why they’re important concepts.
Let’s start with some terminology and why I prefer to invest in recovery situations rather than turnarounds.
A turnaround situation: A company which hasn’t produced good returns for at least ten years and is trying to turn that situation around.
A recovery situation: A company with a long and successful track record which has fallen below its previously expected standards over the last year or two. The company is trying to recover back to its historic standards, or better.
I’m not interested in turnarounds because I only want to invest in companies with long and successful track records. But I am interested in recovery situations.
With recovery situations there are (at least) two important factors:
- The fitness, or competitiveness, of the existing business
- The amount of fatigue, stress or damage, which has been inflicted upon the business, from which it is hoping to recover
The fitter the company, the more fatigue (stress or damage) it can withstand, and the faster it can recover and improve.
Conversely, the more unfit the company, the less fatigue it can withstand, and the longer it will take to recover and improve.
Here’s a somewhat lengthy analogy:
Imagine a young athlete, who trips over whilst walking down the road.
Fitness is high, fatigue from the fall is low, so the athlete quickly gets up, recovers and continues to walk down the road.
Imagine the same athlete sprinting down the road and then tripping over. Fitness is high, but fatigue from a high speed fall is also high, so it might take a few minutes for the athlete to get back up again and a few days for the cuts and bruises to mostly vanish.
If we replace the young athlete with an old geezer (such as myself) then the story is very different.
The old geezer trips whilst walking. The fall is minor, but because the old geezer is unfit and has slow reactions, the amount of fatigue from the fall is higher than it was for the athlete. And because the geezer is old, it takes him five minutes to get up and several weeks for the bruises to disappear.
The same old geezer then trips whilst running at high speed (which isn’t that high to be honest). Fitness is low, fatigue is very high and the old geezer breaks his nose, several bones in his hand and has concussion. He’s in hospital for a week and takes months to recover fully.
That is a very long winded way of saying that for me:
- ‘Turnaround’ situations (consistently weak companies that are looking to improve their performance) should be ignored
- ‘Recovery’ situations may be suitable investments but only if:
- The fitness of the underlying company is reasonably good at the very least (i.e. the company has a successful track record with some growth, decent returns on capital employed, prudent debts, etc.)
- The amount of fatigue from which the company has to recover is low (e.g. is likely to take less than a year or two, not require lots of debt or the suspension of the dividend, etc.)
Let’s whiz through a couple of examples and then we can look at the topic of transformations.
Serco 2013: A weak company facing a major problem
My investment in Serco is a good example of what happens when a company with very low fitness faces a large amount of fatigue.
Low fitness: When I bought Serco in 2013 it was a support services company providing all manner of services to prisons, railways, the Ministry of Defence and many others.
This is an industry where winning multi-year, multi-million pound contracts is vital. The only problem is that multi-million pound contracts mean lots of due diligence and careful analysis from customers, and lots of competition from peers.
And that means very little margin of safety from profit margins (Serco’s net profit margins averaged 3.4%) and anaemic returns on capital employed (averaging 8.6%).
As well as being weakly profitable, Serco was fragile thanks to large debts (a Debt Ratio of 7.6, way over my current limit of 4.0) and excessive acquisitions (over £1 billion spent in the previous decade; almost as much as the company total ten-year profits).
High fatigue: Back in 2013, Serco was under investigation from the Serious Fraud Office for irregularities in the way it charged the government for some services. The company lost contracts and for a time was banned from bidding for any government work.
That was bad enough, but the company then had to write down the expected value of other existing contracts by £1.5 billion, following a detailed review of the company’s procedures.
This sort of loss of future profit, plus the loss of trust with customers, would be a major blow to any company, let-alone a weak company like Serco.
With wafer thin margins and an already highly leveraged balance sheet, Serco’s ability to withstand this level of stress was massively impaired. The company and its share price have yet to fully recover.
Now older and (hopefully) wiser, this is exactly the sort of situation I will try to avoid in future.
Homeserve 2013: A strong company facing a minor problem
If you’re looking to invest in a recovery situation, what you want (or at least what I want) is a strong company facing a minor problem, and where the market is more worried than it should be (i.e. the share price is available at a bargain price).
I think a good example of this is Homeserve in 2013.
Like Serco, when I invested in Homeserve in 2013 it was under investigation; this time from the FCA in relation to dubious tele-sales and marketing practices.
High fitness: Homeserve sells insurance for home maintenance and emergency repairs, covering things like burst pipes and broken boilers.
Unlike Serco, Homeserve had a good margin of safety from profitability (average net margins of 12.7% and average returns on capital employed of 16.4%) and a strong balance sheet (a Debt Ratio of just 2.4, well below my limit of 4.0).
It was a fairly acquisitive company, but total ten-year acquisitions only came to 50% of total ten-year profits; half the level at Serco.
These and other features of Homeserve’s business made it much fitter and much more able to cope with and recover from stress than Serco.
Low fatigue: Although the investigation from the FCA was serious (in the UK, Homeserve was banned from using tele-sales or tele-marketing for a short while) there were no major knock-on effects.
The company re-trained staff and brought in new sales and marketing processes and rules, there was little impact on relations with customers and partners, and the company’s reputation and financial results were not seriously impaired.
Within a year or so the company had fully recovered, and if anything was in an even stronger position with better sales and marketing processes than before.
This led to a fairly rapid recovery in the company’s share price and the company and its share price have continued to prosper.
This is the sort of recovery situation I will be happy to continue investing in, which means coming to a reasonable conclusion about the fitness of the company and the degree of fatigue it’s facing are key.
Of course, not all recovery situations will work out perfectly, but I think investing in a fit company facing a limited amount of acute fatigue is an attractive proposition at the right price.
I’ll leave the last word on recovery to Warren Buffett, here talking about the rare but enormously profitable opportunity provided when extremely fit companies face large amounts of short-term stress:
[…] a great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, problem as was the case many years back at both American Express and GEICO
Warren Buffett, 1989 Letter to Shareholders
Transformations: The buggy whip manufacturer’s last stand
“If you put [exceptional managers] to work in a buggy whip company, it wouldn’t have made much difference.”
Warren Buffett, from a 1993 Forbes Magazine article by Robert Lenzner
Unlike turnarounds or recovery situations, transformations don’t necessarily coincide with any specific event or acute cause of fatigue.
Instead, transformations occur when a company’s core business is facing a permanent (though not always terminal) decline.
Transformation: When a company’s core business is facing long-term, permanent decline, and where the company is trying to offset that decline by moving into new markets, sectors or industries.
If you want a somewhat overly optimistic analogy, think of a caterpillar turning into a butterfly. There is the demise of one business (crawling around eating leaves) and a transformation into another business (flying around, eating nectar and mating).
This is different to a recovery or turnaround situation because the key to success is not to reverse the decline of the old business, but to move away from that business to something else, which may or may not be that closely related to the old business.
Transforming a business is not easy to do, and I think there are two main factors which determine the odds of a transformation succeeding:
- The pace of decline
- The ultimate extent of decline
The pace of decline: For some companies, the speed of decline in their core business is dramatic.
Examples of rapid decline include ‘information retailers’ such as Blockbuster, HMV and Our Price. Each of these companies died off in just a few years as information (i.e. video and music) moved from physical to electronic distribution channels.
One of my current holdings, N Brown (the age 50+ and size 20+ fashion retailer), is another example of a company whose traditional core business is in relatively rapid decline.
That traditional core business is a catalogue home shopping business. It still exists, but it’s been in increasingly rapid decline for several years thanks to the arrival and dominance of Web-enabled tablet and phone computers.
I will be amazed if N Brown’s home shopping catalogue business still exists ten years from now.
But not all permanent or terminal declines are rapid.
Think of tobacco companies, which are, to varying degrees, in the process of switching from selling cigarettes to selling ‘next generation products’ (e.g. e-cigarettes and vaping products).
Their core business is in a slow, multi-decade decline because young people aren’t smoking as much as their parents, either by choice or because cigarette packets are now the same colour as poo.
Or think of oil and gas extraction companies, whose core business is likely to enter a slow, multi-decade decline as wind and solar become enormously cheaper ways to generate energy.
So if you’re looking at a company whose core business is in decline, look at how quickly that core business is declining and think about how quickly it might decline in the years ahead.
And if it is declining rapidly, ask yourself this:
Is it realistic that the company could transform into a new and successful business in just a few years?
The ultimate extent of decline: As well as the pace of decline, the extent of decline also matters.
After all, not all buggy whip manufacturers went bust when cars replaced horses as a means of transport. Some survived, although of course in a much smaller market.
So not every permanent decline is a terminal decline.
Perhaps N Brown’s catalogue business will continue to operate for many more decades, serving the needs of those who don’t like using the Internet. But it will be a tiny and irrelevant part of N Brown’s business, regardless of how successful or not N Brown’s transformation into an online-first retailer proves to be.
Another example of a permanent but not necessarily terminal decline is Connect Group, the UK’s leading newspaper and magazine distributor.
There is no doubt that its core business is in decline and will continue to decline along with the number of people who read paper newspapers and magazines.
But I don’t think it has to decline to zero. Some people, like me, actually prefer to read paper newspapers, books and magazines, so there will probably be a market for Connect’s distribution services long into the future; just on a much smaller scale than today.
It’s a borderline case, but I would also lump GlaxoSmithKline (which I recently sold) in with these ‘permanently but not terminally declining’ businesses.
Glaxo is working through a patent cliff, which means it’s permanently losing large chunks of its business as old patents expire.
Replacing those patents is, in terms of difficulty and uncertainty, more like building a new business than improving an existing one.
In fact, Glaxo is effectively building two new businesses by carrying out various product swaps and joint ventures with competitors, and raising the prospect of a complete split (into separate pharma and consumer healthcare businesses) in a few years.
That’s why I’d class Glaxo as a partial transformation rather than a recovery.
Having said all that, as Blockbuster, HMV and Our Price show, there are many businesses where the decline really is terminal, and where the company has no choice but to either completely reinvent itself (a non-trivial problem) or go bust.
Big acquisitions: The default route to transformation
While it may be possible for a company to organically grow a new business to replace its declining core business by reinvesting existing cash flows, it’s unlikely.
In most cases there simply isn’t enough time to organically grow a replacement business, so the preferred route is almost always through large acquisitions.
Connect Group is a good example of this.
It’s core newspaper distribution business has been declining by single digit amounts for years, but instead of accepting the decline and returning all excess cash to shareholders so they can reinvest it themselves, management chose to buy other businesses in an attempt to maintain or grow the company.
As far back as 2009, management had a strategy to ‘diversify’ the business, buying up book wholesalers, library supply businesses and suppliers of educational materials.
None of that seemed to work very well, so the company ‘refocused on its core’ and divested the lot.
After that, the company spent just over £113m acquiring Tuffnells, a parcel distribution business famous for its “Big Green Parcel Machine” lorries. Tuffnells has had its fair share of problems recently, but it has yet to be divested.
So if you see a company making lots of relatively large acquisitions, ask yourself:
- How closely related are the acquisitions to the company’s core business? Acquisitions that have little to do with the core business may suggest that the core business has had its day (look out also for ‘diversification’ strategies; in my experience these are rarely a sign of strength)
- How has the company’s existing core business performed? While the headline results may be going up, is that all down to acquisitions? Try to pick apart the performance of the existing core business. If it’s declining, beware.
However, acquisitions aren’t the only way to go.
In some cases, the company is lucky enough to have a part of its core business which is viable.
This is the situation at N Brown. While its home shopping catalogue business is shrinking rapidly, several key brands (primarily Simply Be) are growing at very reasonable rates in the online world.
So although N Brown is in the middle of a difficult transformation from an offline home shopping business to an online retailer, it does at least have several valuable and relatively easily transformable assets.
Transformations: Just say no
Although I have invested in transformations in the past (such as Glaxo and N Brown), I won’t be looking to add to that tally in future.
Transformations involve massive amounts of uncertainty and therefore risk.
It is extremely difficult, even for a company with ridiculous levels of dominance (e.g. Connect’s newspaper delivery business has 55% market share), to successfully build or buy its way into another sector or industry.
Existing companies in those sectors have far more experience and customer and supplier goodwill, and they don’t have the mental or financial drain of a declining core business to deal with either.
In most cases I think companies facing secular (i.e. not cyclical) decline should accept their fate and decline with grace, returning excess cash to shareholders rather than desperately reinvesting it with little chance of success.
Either way, from now on I’m going to follow the example of Warren Buffett and try to avoid transformations altogether:
After 25 years of buying and supervising a great variety of businesses, Charlie [Munger] and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.
Warren Buffett, 1989 Letter to Shareholders
I’ve realised that as a minority investor it’s not possible to influence the management of a company. For this reason, I tend to avoid situations which involve turnarounds.
What I tend to favour is buying stocks of a company where short term negative outlook has wiped out the price by a large margin. However, the company is still in good health and has a very strong cash flow with an extremely wide moat.
Apple comes to my mind. However, the stock for Apple is still too expensive if Apple stock crashed to 4% dividend with a stock price of $80 approx then I would take notice. At current price, Reckitt Benckiser is a safer company. Reckitt Benckiser has a collection of powerful brands that have strong pricing power and relatively resistant to change in an economic downturn. The company also offers a dividend of 2.8%.
I am keeping an eye out on RB should Mr Market be in a foul mood I’ll be happy to assist.
John Kingham says
Hi Reg, that’s my dream situation too. An excellent company going through a minor non-event but where Mr Market has blown things out of all proportion.
Those are pretty rare though. Most of the time the price either isn’t obviously cheap or there is some material problem which increases the uncertainty around how things will pan out.
As for RB, I have bought and sold it before and would buy it again at the right price, although I’d like to see its debts come down a bit following the Mead Johnson acquisition.
“As for RB, I have bought and sold it before and would buy it again at the right price, although I’d like to see its debts come down a bit following the Mead Johnson acquisition.”
I think leverage is only an issue if the business itself is weak and inadequate. Leverage offers a wonderful opportunity to maximise investor returns because issuing equity is a far more expensive route of raising capital compared to leverage.
The thing we should take into consideration when high levels of leverage are identified is what type of company is it? For example, Johnson & Johnson has a wide moat and increasing cash flow which is fairly predictable. Therefore it can actually increase returns to its shareholder by using leverage. However, its imperative to ensure the debt is being used sensibly i.e. overpaying for an asset can destroy value for the shareholder.
On the other hand Tesco, Morrisons and Sainsburys are low margin commodity business if I wish to buy a box of Persil or Dettol I will look to see which supermarket offers the product at the lowest price as this falls into a monthly shopping category allowing me to plan ahead. This leaves them with a low margin business because to attract customers they have to be competitive on price. Therefore if I saw these companies with even slight debt I would get more nervous.
John Kingham says
I guess I’m just less confident than you in the future success of specific businesses.
For example, for more than 20 years Tesco was a defensive growth machine, with net profits going from £400 million in 1992 to almost £3 billion in 2012 and a dividend that went up every single year.
But eventually it ran into a very tough market at a time when it had over-extended itself due to over-enthusiastic management, e.g. total borrowings were about £12 billion (about 6-times average profits of the previous decade) when the wheels fell off.
So Tesco was a 20-year-plus defensive dividend champion, just like RB and Unilever, and it still fell over (and is still trying to get back up).
And as with Tesco, Unilever or RB or the other consumer packaged goods companies could also fall over if they run into tough competition and tough markets at a time when they’re over-leveraged.
For example, imagine Amazon selling its own-brand soap, toothpaste and so on. They would be ‘good enough’ for 95% of people, and very probably much cheaper than Unilever’s or RB’s alternative. In the future everyone will buy almost everything on Amazon (in this example anyway), and get automated recurring orders, all through Amazon’s Echo/Alexa devices.
RB’s sales would take a permanent hit, as would its margins. Just like Tesco.
So while RB may be a quality company, that doesn’t give it a free pass to a prosperous future. Hence the need for cautious levels of debt.
And I don’t mind a bit of debt to make an acquisition, but the post-acquisition focus should be on returning debt to prudent levels as soon as is practical.
Everything you’ve said is true I can’t dispute the facts you have stated. For this reason, I do have very stringent criteria when I look at a company loaded with debt.
1) Firstly the company needs to have 15 to 20-year history of high returns based on tangible assets. This would indicate that the company has a very wide moat and it requires little in the form of investment to grow meaning high FCF. For example, Tesco generated profits of £505 million from equity of £3,876 million in 1999 profits increased to £1576 million in 2006 but the equity increased to £9,444 million. Under the same time frame if we look at Colgate it generated $937 million profit from equity of $366 million in 1999 profit increased to $1,300 billion in 2006 and equity decreased to $222 million. 1999 to 2006 represents Tesco golden years but if you compare its performance to Colgate it leaves it in shades. Also, toothpaste is an intimate product and most people use a specific brand familiarised through childhood. The idea that Amazon can muscle in with their own version is very unlikely.
2) Margin of safety, like you, said its impossible to foresee what will happen therefore I am unwilling to buy a stock unless it offers me a higher dividend yield than normal to give a margin of safety. For this reason RB stock needs to crash before I would be prepared to invest in such company because at low yields of 2.8% the margin for error is low but at 4-5% I think it makes it more tolerable.
I know this strategy may not be to everyone’s comfort.
” Under the same time frame if we look at Colgate it generated $937 million profit from equity of $366 million in 1999 profit increased to $1,300 billion in 2006 and equity decreased to $222 million. ”
Just realised the figures were incorrect in case anyone does wish to look into the figures for Colgate. Corrected figures as following:
“Under the same time frame if we look at Colgate it generated $937 million profit from equity of $1833 million in 1999 profit increased to $1,300 billion in 2006 but equity decreased to $1410 million”
John Kingham says
Thanks for these detailed comments; they’re very useful for other investors who stumble across these pages.
Overall we’re in agreement. Try to buy ‘good’ businesses with attractive levels of profitability, prudent debts and a high probability of future growth. And try not to overpay.
John, How are you viewing PZ Cussons after the recent results and sell off?
I sold this at 320 last year and bought it back last week at 176.
Africa is only 10% of the overall profit despite having a high sales number, all the other regions grew profits. The balance sheet is seemingly ok and the net debt reduced.
Has a long history, I think it’s going to bring things in line if the Nigerian ports are resolved and the currency stabilises, they quite often do.
John Kingham says
Hi LR, PZ has certainly jumped up the rankings on my stock screen. It’s slightly outside my top-50 which is where I usually restrict buying to.
What seems to be holding it back is its somewhat weak profitability (average of ROS and ROCE is < 9% and I prefer > 10%) and its reasonably but not excessively high debts.
I think if the dividend yield nudged north of 5% I might be interested, although I haven’t looked at the company in detail.
Hey John, great article. What’s your take on IMB or BATS that have taken a (IMO overdone) hug hit due to regulatory fears last year? I personally see both as very good value specially from a dividend standpoint. I’m -17% on BATS and +8% on IMB and will probably be adding to both at these levels.
Dividend seems well covered by FCF and volume declines are being compensated by price inelasticity.
John Kingham says
Thanks. They both look fairly attractive to me from a valuation point of view. As you say, that’s because of ever-tightening regulation, so there are clear risks, but I’ve owned BATS for a few years and am happy to keep holding at its current price.
IMB is similar, but due to its acquisitive history and regular large amortisation expenses its reported earnings and returns on capital don’t look as attractive to me as BATS’. However, its cash flows seem healthy so while I don’t own IMB I can see why many investors do.
Really a great article you’ve written here, congratulations on it.
I was wondering what you think about Aryzta (ARYN), as they are a renowned company in a pretty decent growing field of business with many years of success but with a big problem during the last 5 years. The management was almost entirely replaced and they are now trying to achieve the turnaround. In my eyes the H1 19 as well as the Q3 19 reports show some solid numbers and quite an optimistic glance into the future but still the stock market does not seem to recognize it. According to your opinion, am I missing out something important or is it just hard to win the trust of the investors back?
John Kingham says
Hi Samuel, unfortunately I don’t know anything about that company. However, I would say that it can take a long time (years, not just a few months or quarters) and a lot of solid evidence that the turnaround has really turned before investors are willing to bid the share price up again, especially if the problems were serious enough to require a new management team.