Most brokers have been in the situation where a new client comes aboard or transfers into the firm with stocks already existing in their account that are down dramatically from the initial purchase price. These customers will often ask the question: "Should I hang onto these stocks, or sell them?" What you do next will truly determine if you're savvy as a registered representative. Do you know what to look for in a potential turnaround stock? We'll give you a few key signs to point you in the right direction.
Sniffing out a Future Winner
In the case of stocks with poor performance, your goal as a broker should be to determine whether those beaten-down stocks in your client's portfolio are worth hanging onto. This is not an easy skill to acquire, but there are few key signs to look for in determining whether a company has the potential to turn things around and increase its stock's performance.
See: Stock-Picking Strategies
1. New Products
Are there any new products that have recently been released, or are about to be released? Increased advertising tends to go hand in hand with new product introductions. Often, this advertising will draw investors, who will drive the stock price higher. (For related reading, see Advertising Crocodiles And Moats.)
To be clear, advertising alone will not stimulate a long-term turnaround situation. That is why, as a registered rep, you need to analyze whether or not the new products have a chance at success. If they do, what will the "revenue ramp" be? How much will the new product contribute to sales over the next year, two years and beyond?
If you can say with some degree of certainty, that the new product has a reasonable chance of increasing sales and profits markedly, consider holding the stock.
2. New Management
Sometimes a company just needs to clear the slate and bring in a new team with fresh ideas. While new people are no guarantee of success, they are often motivated to find solutions to the company's woes fast! This means that they will be doing their utmost to prove themselves to the board of directors by enhancing shareholder value. They may introduce new products, cut costs and/or make strategic acquisitions or dispositions of assets.
So take note of any new management changes. If what the new management team is doing to improve shareholder value makes sense, consider holding onto the shares. (For more on this, see Evaluating A Company's Management and Putting Management Under The Microscope.)
3. Gross Profit Improvement
Companies must not only be able to sell their wares at a good price, but they must also be able to buy raw materials at a good price. To that end, improving gross profits will tell you whether the company is buying its materials wisely. It is also usually a predictor of an improvement in earnings growth.
Remember that gross profit is calculated as follows:
|Net Sales - Cost of Goods Sold = Gross Profit|
4. Share Repurchase Programs
Management has a host of choices about what to do with the company's cash. It could hire more people, make an acquisition, return the cash to shareholders in the form of a dividend or save the money for a rainy day.
Management can also repurchase its stock in the open market. If/when this happens it may be construed as a sign that a company is in the midst of a turnaround or is expecting improved earnings. Why? Because management needs to produce results for the board of directors and the shareholder. Therefore, if management spends the company's precious cash to repurchase stock, this speaks volumes about its view for the future. (For more insight, check out A Breakdown Of Stock Buybacks.)
5. Increasing Analyst Coverage
If a company is on the rebound, you will start to see new analysts pick up research coverage, or raise their ratings on the stock. This increased publicity usually comes before or in the midst of a turnaround.
Also, keep in mind that analysts can sometimes act like sheep, in that they tend to travel in herds. Simply review any of the bigger data collection agencies such as Thomson Financial for evidence of this. Therefore, you'll need to look for instances in which an analyst ratchets their earnings estimates up or down, or initiates coverage. Typically, that action is followed by other similar actions at competing brokerage firms. This chain of new coverage, in itself, also tends to be a great publicity generator that draws investors and drives the stock higher. (For related reading, see Research Report Red Flags For Brokers.)
6. Insider Buying
It is often a good sign when officers and directors are spending a large amount of their own personal money buying the stock on the open market. Remember, there are lots of reasons why an executive might sell their stock, such as buying a house, or putting a child through college. However, there is usually only one reason why an individual buys a stock: to make money.
By law, insiders must file what is called a Form 4, which details their purchases and sales. This information is available to the public on the SEC's website. (Find out what to look for when analyzing insiders buying habits, see What Investors Can Learn From Insider Trading and When Insiders Buy, Should Investors Join Them?)
7. Increased R&D Spending
While there is no guarantee that a company that spends a great deal of money on research and development (R&D) will be successful in its efforts, it is typically a good indicator that a new product or service, or an improvement to an existing product or service, might be about to hit the market. Take a look at the company's quarterly income statement. Is the company plunging a lot more money into research than it did last year? If so, this may signal a turnaround is in the works.
Be cautious when looking at an increase in R&D spending if a company's share price has continued to suffer while R&D spending is high. In such cases, a turnaround may not be in the company's future. ((For more on this, check out Buying Into Corporate Research & Development (R&D).)
8. New Building or Acquisitions
Companies that have fallen on tough times usually try to "grow" their way out of trouble. If internal growth isn't an option, they look to expand by opening new facilities in different markets or buying other businesses. While this can also be a big risk, there is a possibility that the company's actions can lead to increased profits. You can find this information by reading a company's press releases. Get to know its strategy and try to determine if and when the expansion or acquisition will have a positive effect on the company's bottom line.
The Bottom Line
There are many potential catalysts that can turn a company around. As a professional, your job is to try to analyze the different possibilities and see if they make good business sense. Keep in mind that you can always sell off your client's stock and generate a quick commission (albeit at the risk of being investigated for churning), but growing your clients' assets and/or improving their income streams should be your primary goal. Know what signs to look for when trying to determine whether a turnaround is in the cards - if you impress your client, you'll both be glad you did.
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