It's a Prime Time for Tech Turnarounds

Nine months, a new management and a restructured balance sheet later, the stock could still be purchased for under $13. Tyco had always been a solid collection of decent businesses, but now the balance sheet and management issues had been resolved.

Why didn't the investment community get it? As one of few vocal longs, I was annoyed and frustrated by the market's unwillingness to recognize the improvements. I still had to wait, but not that long.

By the second half of 2003, the market started catching on. Despite an ever-lowered earnings forecast for that year, the stock surged to $25. At that point one could have made the case that Tyco was fully priced. Many value investors, myself included, pitched the shares on a valuation basis.

The stock has risen another 23% this year and continues to gain sell-side sponsorship on a regular basis. A company promoted by the shorts as worthless 18 months ago now sports a P/E of 20 and a $65 billion market cap. So much for cheap. My guess is that many Tyco players, both longs and shorts, got a healthy dose of frustration on this trade.

Be Skeptical

What actually happens to many stocks in this situation? We believe that company managements and analysts' published reports tend to underestimate changes in fundamental conditions, both positively and negatively. When things turn sour, corporate managements often deny the true scope of the problem. With bad managements, they may even be the problem. Analysts tend to give their companies the benefit of the doubt. It is only after the problems are severely obvious that the official party line finally changes.

Investors, however, have long recognized that the fundamentals swing more rapidly. Therefore, they tend to factor a worst-case scenario into share prices as the problems develop. They place little emphasis on the party line or Wall Street forecasts.

Once the fundamental issues have been corrected, they acknowledge normalized earnings power much faster than just-burned management or sell-side analysts. Investors realize that the "growth" of a successful turnaround is much higher and more visible than conventional growth. Growth and momentum investors place a premium valuation in highly visible recovery stories and keep the stocks ahead of the fundamentals.