Investing in turnarounds, recovery stocks and corporate transformations

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:

1. Why I’ll be looking at reported earnings instead of adjusted earnings from now on
2. Why I’m measuring capital employed growth instead of earnings growth
3. Companies with thin profit margins often make bad investments
4. 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.

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:

1. The fitness, or competitiveness, of the existing business
2. 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:

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.

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:

1. The pace of decline
2. 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:

1. 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)
2. 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