Finding Fixable Turnarounds

The allure of turnaround stocks is obvious: investing in successful turnarounds can be very profitable. What is not obvious, though, is how to best sift through the large number of stocks that qualify as potential turnarounds.

Potential turnaround situations will evolve in any number of directions. Some will result in huge wins for investors, but there will also be companies that don't turn, and when a company's turnaround efforts fail to measurably improve operations, the stock will follow suit and fail to improve as well.

The turnaround situation that every investor wants to avoid is when a company "turns down" instead of turning around. For example, Interstate Bakeries brought in new management over a year ago to effect an operational turnaround, only to see the company's fortunes take another leg down. The stock recently entered bankruptcy protection because of a liquidity squeeze.

In an effort to help investors avoid turnaround situations like Interstate Bakeries, I'll try to answer these questions: How can an investor best sort through potential turnarounds? What rules can an investor follow to ferret out the winners from the losers?

Analyzing the Fixability of Potential Turnarounds

Without exception, turnaround companies are beset by problems. Some problems can be fixed. Some can't. It follows, then, that the key variable for investors to analyze is the fixability of the problems.

Legacy airlines such as U.S. Airways , Delta (DAL - commentary - Cramer's Take), American (AMR - commentary - Cramer's Take) used to be much bigger and stronger than Southwest (LUV - commentary - Cramer's Take) and other low-cost carriers. But being bigger and stronger is not the controlling variable when the operating environment changes.

The high-cost structure and hub-and-spoke delivery system of the legacy carriers does not work as well the low-cost, point-to-point delivery system of the discounters. The problems plaguing the legacy carriers are almost impossible to fix.

In assessing the fixability issue for a potential turnaround, an investor needs to pay careful attention to the balance sheet. This is the fulcrum upon which many turnarounds will turn or not. Here my "Rule of Flexibility" is a useful construct: the alternatives available to management to effect a turnaround are directly related to the strength of the balance sheet.

In other words, the stronger the balance sheet, the greater the flexibility accorded to management. Weak balance sheets, on the other hand, provide management with a limited array of options to effect a turnaround.

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At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, 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].