The Life Cycle of a Turnaround Stock

All stocks are cyclical. No business grows in a linear trajectory in perpetuity, so don't bother trying to find one.

Here's the irony: When a company is lucky enough to pull off several years of consistent, strong growth, Wall Street grants it a rich valuation --- precisely when skepticism is in order. The expectation game gets played. Perfect companies have to deliver perfect results --- or else.

As I've said before many times, there are only two kinds of companies: those that have problems and those that are going to have problems.

Here are two reasons why I'm attracted to companies with problems, which I call turnaround stocks.

• That's where the bargains are! It's impossible to find a good bargain among companies that are hitting on all cylinders, where everything is going well.

• Everyone knows about the negativity at these companies, so the bad news is fully reflected in their stock prices. Unknown negativity is what poses substantial risk to shareholders.

In other words, if the market knows about a company's problems, it immediately discounts them into the stock price. A basket of bad-news stocks can carry lower risk, then, because the prices are discounted and the negativity is known. However, good-news stocks carry a higher risk, because they are fully priced, and any negativity is unknown.

Evolution of a Turnaround Stock

The life cycle of a turnaround stock generally follows a pattern: There's a period of defensiveness and denial by management, followed by a purging phase.

Tyco (TYC - commentary - Cramer's Take) is a good illustration of a company that went through these phases. The company went through several months of defensiveness and denial before new management, led by CEO Ed Breen, initiated the purging phase, putting the negatives on the table for all to see.

The purging phase is important to the turnaround investor. It often, but not always, coincides with a new management team. It marks the lowest-risk entry point for purchasing the stock. The price point reaches a nadir because all of the negativity, and then some, is priced into the stock. That doesn't mean it's easy to spot. I missed the low in Tyco stock, for example, by overestimating the balance sheet problems and underestimating Breen's ability to improve operations.

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At time of publication, Alsin and/or ACM was long Boeing and UnumProvident, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, TheStreet.com Value Investor.