How to Spot a Turnaround Stock

With Internet stocks seemingly destined to reach triple-digit prices regardless of their underlying business model (or lack thereof), the very concept of value seems to have been forsaken by many investors.

The current no-mistakes, execute-or-die climate on Wall Street makes the turnaround play seem somehow quaint -- an anachronism from a bygone, gentler era when thoughtful investors actually gave a great company time to right itself from temporary woes.

A few of us enlightened souls remember Peter Lynch's triumph with Chrysler. Or, earlier, Warren Buffet's success with American Express (AXP). OK, so maybe you can't resist the prevailing quick-buck mentality, but should there still be a place for value to percolate in your portfolio? You bet! And here is how to find it, even among today's highflying sectors.

As chief investment officer of a small investment advisory, I track best undervalued growth stocks -- or BUGS -- and can assure you that value investing is alive and well. The basic technique for spotting value in rapid growth fields is easily learned. How do BUGS differ from other sick stocks? What follows is a case study of a recent BUG we uncovered and that ultimately snared a 70%-plus gain in under a year.

Almost every week, a once-highflying growth stock suffers a sudden catastrophic plunge in its share price, thus entering our BUG-tracking pipeline. On Dec. 18, 1997, it was Plexus (PLXS).

First, the Fall

Shares of the Neenah, Wisc.-based electronics manufacturing services, or EMS, provider nose-dived from 25 to 14, or 44%, on fears of slowing sales. A quick check of Investor's Business Daily revealed that this BUG passed our initial screening criterion: Prior to the debacle, Plexus' earnings momentum was within the top 10% of all publicly traded firms. A chart showed Plexus had peaked two months earlier, losing relative strength dramatically since.

Next, a quick tour of my favorite Web sites revealed that over the years, Plexus' revenue, net income and earnings had all consistently grown, return on equity was high, price-to-sales was reasonable and the company ended its fiscal year with more cash on hand than long-term debt.

Billing itself as "the product realization company," Plexus was clearly benefiting from the trend toward high-tech outsourcing among major original equipment manufacturers seeking to reduce their capital expenditures, product time-to-market cycle and carried inventory.

The company offers itself as an extension of customers' engineering and manufacturing operations. It provides contract development, design, prototyping, material procurement, inventory management, volume manufacturing and test capabilities to companies such as General Electric (GE), IBM (IBM) and Motorola (MOT) in the telecom, computer and transportation- and medical-electronics fields. The opportunity is real: By 2000, the global EMS market is projected to reach some $145 billion, and a handful of players, including Plexus, stand to reap huge contracts.

Growth Slowing, but Still Positive

After obtaining and thoroughly reading the annual report, there was little left to ponder. The company was serious about improving its bottom line: Inventory turns had increased from 3.7 times in 1993 to 6.7 times in 1997, while the overall sales cycle had shrunk from 74 days in 1996 to 57 days in 1997. A brief follow-up telephone conversation with Plexus' chief financial officer, Thomas Sabol, revealed that although sales and earnings were running below expectations, they would end the year at higher levels than they did before. Growth was slowing, but was still positive.

Impressed, I added Plexus to our BUGS model portfolio on Feb. 17, 1998, at 19.06. (Our model portfolios are used to track average performance. Variations in our clients' starting dates or account size can -- and often will -- produce differing results.)

If anything, I bought too soon. Subsequent refinement of our methods revealed that the optimal time to buy a BUG is often 30 to 40 weeks after the initial plunge. That leaves enough time for the other shoe to drop and for slumbering management to wake up and take corrective action. It also prevents prudent BUG-hunters from becoming trapped in "dead money" positions too long, while giving any would-be corporate suitors time to contemplate acquisition strategies.

Often, a highflyer suffers its first serious stumble, becomes a BUG and is quickly snapped up by a competitor that realizes the company's underlying value. For example, Chipcom was bought by 3Com (COMS), Baby Superstore by Toys R Us (TOY) and Scopus Technology by Siebel Systems (SEBL).

The Trick Is in the Timing

If a BUG has strong fundamentals, a good niche, competitive advantage, more available cash than long-term debt, is cash flow positive and can defend at least some thickness of margin -- then its business should not only survive, but its battered stock price is almost certainly headed for a sizable comeback -- perhaps on a takeover bid. The trick is verifying the above criteria, timing entry and exit points and steeling one's nerves against prevailing opinion.

In the case of Plexus, things turned around promptly. Sales and earnings perked up, Wall Street's cloud of gloom lifted -- we sold half our position on Nov. 23, 1998, at 28.75 and the rest on Jan. 21, 1999, at 36.50, bagging an average 71% gain.

Not every turnaround candidate becomes a comeback kid, and some BUGS really do get squashed quite messily in the end. But adding a few carefully chosen BUGS to your portfolio can spice up returns nicely, while providing some degree of market neutrality. Just remember: Be thorough, be patient and be daring.

>To order reprints of this article, click here: Reprints