There are four signs that can help you spot a possible 10-bagger recovery play:
1: Decent products
Focusing on struggling companies that produce a decent underlying product has a two-fold benefit. First, the company is more likely to continue selling the product, and so keep cash coming in, which can itself be the difference between survival or not.
Second, there's always a chance a rival may want the product for itself and attempt to get hold of it on the cheap with an opportunistic bid. If a product is too easily replaced by someone else's, avoid it. Nervous customers and suppliers may jump ship and push the company deeper into trouble.
2: One-off problems
There's always a much better chance of a turnaround if it is a single, clear and solvable problem in the first place. They are much easier to sort out with swift action. It is also important that there is clear evidence that sales growth has not gone off the rails completely. A company may have seen its profits wane because of rising costs, but this is often a short-term consequence of expansion, and, by and large, is reasonably easily solved. It is much easier to make lifesaving cuts to a rising cost base than it is to suddenly turn on the revenue tap. On the other hand, firms warning on profits following a slump in sales should set alarm bells ringing since this is often the first sign that a company has lost its previous edge over the competition. Unless the company has a proven record of surviving previous industry cycles, these types of companies should be avoided.
3: Fresh management
New management is often the key catalyst to a recovery story. They're not hindered by the emotional baggage of the previous bosses and, as outsiders, generally they find it far less troublesome to take the necessary action to spark the turnaround. New brooms have no sacred cows. Peter Lynch once said: "Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it." But remember, bad businesses in poor industries will be perpetual underperformers no matter who is in charge.
4: Cheap valuation
The shares must have plenty of upside potential if you're going to take on the added risks that come with a recovery story. Current earnings are often useless as a guide in most recovery situations, since profits are likely to be either heavily depressed or non-existent. It's always worth applying a bit of common sense to work out what the future profits prospects of a company might be.
Look at the current sales, profits and operating margins to make a sensible stab at what these respective figures might look like post-recovery. That way, you can make a reasonable estimate on future earnings and work out what sort of forward price/earnings (PE) ratio the shares are trading on, and, importantly, what the PE ratio might rise to once recovery really starts kicking in. Look for single-digit PEs now that could turn into double-digit ones over the medium term. If it comes off, you'll get the double whammy of a decent rise in profits plus an upward re-rating of the shares. For example, a current 90p share price on 15p EPS would mean a PE of 6. If you get your sums right, EPS could rise to 18p (20 per cent increase) and spark a PE of 10 – that would mean 180p shares, twice the original amount, and well on the way to 10-bagger country.
10-bagger tales from the past
WS Atkins and Cairn Energy wouldn't appear to have very much in common, beyond perhaps a certain familiarity with drills and diggers. And their 10-bagger success.
Cairn has been one of the great oil discovery success stories of recent years. It paid just £7m for exploration acreage in Rajasthan, India, but has since reaped huge rewards thanks to a billion-barrel discovery on its three key oilfields: Mangala, Bhagyam and Aishwariya. Soaring oil prices and implied future cash flows saw investors chase the shares to incredible levels. In early 2003 you could have bought shares for about 25p. Just three years later they shot to more than 250p, and have kept going to over 400p, thanks in part to its 31 per cent exploration stake sale which netted a £480m cash return to shareholders.
The Atkins story was a different kettle of fish. For years it was a rock-solid construction and services company – and consistent share price performer – until it discovered private finance initiatives (PFIs) in 2002. This saddled the company with crippling debts and forced it to axe the dividend after falling £33m into the red. Ironically, the straw that broke this camel’s back was its botched introduction of a new IT billing system, which meant customers were simply not asked to pay up on contracted work.
Yet swift management action and continued revenue growth triggered a sharp rebound, both operationally and in the share price. This meant that the shares, which bottomed out at just 52p in late 2002, had almost become a 10-bagger by the end of the following year. The stock has since gone on to hit pre-recession highs of over £12, and currently change hands for 674p.
What both these stories tell us is that 10-baggers are as likely to be born from the dull and dreary, as from the supposedly sexy end of the stock market.
