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How to Find the True Turnaround Stocks

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July 16, 2011 - How to Find the True Turnaround Stocks - By Zacks Investment Research

It's the dream of every investor to find a stock that is down on its luck and ride it higher to riches.

These are the turnaround stories: companies that were down on their luck for whatever reason, but who are now turning it around.

Who doesn't wish they had bought Amazon.com at $6 a share in 2002 after the dot-com meltdown when many tech stocks were left for dead? It is now trading near its all time high of $218.

Yet for every Amazon.com there is a Webvan or a Toys.com.

Who?

That's exactly the point. It's hard to pick out the true turnaround stocks.

Webvan and Toys.com were also web-based retailers that expanded rapidly in the 1990s. Webvan delivered groceries to homes, much like PeaPod does today. Toys.com tried to do the same with toys by selling them at lower costs than brick and mortar stores.

Neither one succeeded. Webvan and Toys.com no longer exist. Those investors were left holding the bag.

How Do You Separate the Stars from the Duds?

It's obviously not always easy to invest in the companies that are truly turning around instead of those that are going nowhere.

If it were easy, we'd all be in them.

Gladly there are some clues to look out for that will help you find more of these dream turnaround stocks. Here are 4 to consider:

1) It's All About the Good News

The first instinct many have when thinking about a turnaround stock is that something must be wrong with it. There must be some kind of bad news associated with the company for it to be trading at a discount. Right???

The true turnaround stocks will have a clear, positive, fundamental change taking place that tells you it's safe to get on board. Perhaps it's a new management team, product or sales approach that has caused the improvement in the company's earnings trajectory.

Whichever the case, be on the lookout for this good news that acts as a catalyst for earnings estimates to move higher. And that will lead to a significantly higher share price over time.

2) Stocks Trading Under $10 = Turnaround?

Lots of investors think that a stock in the single digits is somehow cheap and will rebound faster. So it MUST be a turnaround stock if it's under $10, right? The answer is WRONG far too often.

A low share price does not automatically mean a company is a turnaround candidate. Webvan and Toys.com both traded in the single digits before going out of business.

Don't get sucked in by a single digit share price. Your dream turnaround could be trading at $20 or even $200 a share. The key is that the current price is low compared to where it will be in the months ahead.

3) Buy the Company, Not the Sector

How many times have you been asked over the years: "are you in tech stocks?"

Tech stocks have been hot for the last decade. In the 1990s it was dot-coms and drug stocks. In the next decade it will be something else.

Don't get fooled into thinking that entire sectors are "good" or "bad". Technology, for instance, usually means a vast universe of different businesses from semiconductors to software developers to anti-virus companies and social media empires. The semiconductors could be struggling even as the social media companies are on fire.

Conversely, just because a sector is "hot" doesn't mean that there isn't a company within it that is finally turning it around - just possibly later than its peers.

Be sure you look at the individual merits of a company because a big turnaround stock can just as easily be found in a red hot sector as one that is currently out of favor.

4) Use the Zacks Rank

Our research team has long noted that true turnarounds can be detected when estimates of a company's earnings suddenly reverse from downward to upward. It's a very good sign when stocks leapfrog from a lowly Zacks #5 Rank (Strong Sell) or Zacks

#4 Rank (Sell) all the way to a Zacks #1 Rank (Strong Buy).

In fact, we now offer a turnaround detection strategy that combines these Zacks Rank movements with valuation and aggressive growth factors. When backtested from 2000-2010, it selected stocks that were over 2.5 times more potent than your average Zacks #1 Rank stocks. Yes, that means the average gain was +45.4% per year. (And as you probably remember, that 10-year stretch wasn't the best for stock investors and yet this turnaround strategy just kept picking winner after winner.)

You might want to look into our new Zacks Rank Turnaround Trader now, because we must limit the number of investors who share its recommendations. There will be heightened interest this coming week because of a special opportunity, and we may have to close the service to new investors at any time.

Find out more about the Zacks Rank Turnaround Trader.

Best,

Tracey Ryniec

Tracey is Zacks Value Stock Strategist and is also Editor in Charge of the Turnaround Trader.

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