A turnaround investment
The term 'turnaround investment' was coined and used by Peter Lynch, the legendary investor who led Magellan fund for over two decades. According to Lynch, a 'turnaround' is a company that has been performing poorly for an extended time but still has the business potential to return to its former self. Finding a turnaround play at an early stage could be a highly lucrative endeavor because the once-failing company is now a much leaner, debt-reduced, highly efficient company. This is why it is usually heading to success.
GM's business - The 2012 model
On October 2012, GM reported Q3 net income of $1.5BL on revenues of $37.6BL. The earnings per share stood at $0.89.
Now, let's try and rewind our clocks one year back. On Nov. 2011, the company announced earnings for Q3 2011. GM reported net income of $1.7BL on revenues of $36.7BL. The earnings per share stood at $1.03.
In other words, earnings per share actually decreased by 13.5% year-over-year. The company's financial position not only did not improve with time but actually deteriorated year-over-year.
When I first recommended GM, shares were trading at the $20 level. They are now resting comfortably at the $30 zone, an increase of 50% in slightly over a year. Just as a comparison, the SPDR S&P 500 (SPY) gained (only) 20% in the course of that same period. Beating the index by 30% is phenomenal. The graph below tells us the story.
The interesting thing is that although EPS dropped by 14% year-over-year, GM shares gained 50% over the same period. This anomaly requires some answers.
The relationship between share price and the core business
There are 2 main possible solutions to the aforementioned discrepancy:
- The EPS indeed dropped by 13.5%, but the main factor of concern among automakers in general, and GM in particular, is the cash flow statement. When we review the cash flow, we can easily find that net cash flow from operations was $3.1BL in Q3 2012 versus only $1.8BL in Q3 2011. That is a whopping 72% increase in the item that really matters the most.
- Oftentimes, a stock is trading at such a cheap price that the company merely has to maintain its business for the share price to reflect its true value. Back in Nov. 2011, GM was trading at a measly P/E of only 5.5x. It is hard to get it wrong when you invest in such a price. Only now, after a 50% increase in share price, is GM trading at a reasonable P/E of 11x and a Price/Sales of only 0.3. This, in fact, is in line with other automakers. Toyota Motor Corp. (TM) and Ford Motor Co. (F) are now trading at a P/E of 12x and 9.6x, respectively, and at a Price/Sales multiple of 0.4 and 0.3, respectively. That means that we no longer have an edge in GM. The price discrepancy has closed and GM is not a bargain anymore.
Some final thoughts
We can never know for sure what the relationship between the price of shares and the core business will be. Sometimes the business is good and the share price is late to catch up, and vice versa. What we do know, though, is that if you buy a share of a company whose business is intact for a bargain price, such as we did in GM, time will sooner or later reward you for your patience.
Since we no longer have an edge in GM, I recommend to sell to close our open position, for no less than $29 a share. We will bank our 50% profit on this investment in a little over a year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.