Day of the dog: Buying banged-up stocks

Even in a rising market, there are always a handful of stocks that no investor wants to touch. Whether it’s Royal Commissions, earnings downgrades, debt problems, or operational issues, a cursory glance at the ASX200 usually reveals one or more names down 50% in a year. Common wisdom tells us ‘not to catch a falling knife’, but for those who can successfully navigate these challenging situations, the rewards on offer can be enticing. In this week’s Thematic discussion, James Marlay from Livewire hosts Steve Johnson from Forager Funds, and Marc Whittaker from Investors Mutual. Topics discussed include; the attributes of an attractive turn around, indicators a stock could be terminal, and they each share a banged-up stock of their own – one that looks attractive, and one that appears terminal.

Edited Transcript

James Marlay: Welcome to Buy Hold Sell. My name's James Marlay and today I'm joined by Steve Johnson from Forager Funds, and Marc Whittaker from Investors Mutual. And today we're talking about buying bombed out stocks, or at least taking a look to see if there's any value there.

There's been quite a few examples of companies having some big falls of late, it puts investors on their toes, but there could also be an opportunity. So let's find out what to look for, what to avoid, and see if there's a few examples that the gentlemen can bring to the table today.

Steve, this is theoretically your forte. I know you spend a lot of time thinking about this and you've got some techniques. First things first, what are the starting points for checking out a bombed-out situation, honey to the bee of the team at Forager?

Steve Johnson: I think when you think about edge as an investor there are a lot of things getting competed away out there and technology is making it harder and harder. And I think one thing that remains is the human tendency to overreact. So we do tend to look at these bombed out stocks and we've had some success and some failures in the space as well, but it's one particular area that we have a good look at.

I think the two key things for us are balance sheet - does this business actually have the capacity to get through whatever problems it's getting through, and perhaps invest in the business if it needs it? And two - is the product or the service viable? Does it actually have something here that people need or want to buy? And I think those are the first two questions for us and some really important ones.

James Marlay: Yeah. I'll just stay with you, vital signs, balance sheets, okay, a business with a bit of value, what are the things that would be terminal? Is it debt, I'm thinking is probably the first one that comes to mind?

Steve Johnson: Yeah, you get into a debt spiral, I think some things that are terminal, definitely the debt side of things is a problem. And I think particularly businesses that are market dependent. If you need capital or you've got a regulator or you're an insurance business that needs to meet certain capital requirements, and the market has lost confidence in you, you get either a very dilutive capital raising if you come in, or potentially a business that doesn't even survive.

So I think there's that and it's not just debt, but does it actually have enough cash and enough flexibility here to get through the downturn and is the business prepared to make changes? I think sometimes a big dominant shareholder in these situations where there's a turnaround can be a problem.

James Marlay: Yeah. Okay. Marc, anything to add to that? What about you? When something flashes up as an opportunity because it's, theoretically, optically cheap, what are the checks that you would run?

Marc Whittaker: Well, certainly we need to know what we're buying, so typically we don't dive into something where we don't understand what's going on, so we want to have a clear and cut view of, well, maybe not a cut view, but we certainly want to have a clearer view of what's going on. There's always going to be an element of uncertainty around a downgrade, or a mishap, or a regulatory sort of an overhang of some kind.

So we really want to understand what's going on, and typically, we'll have a thesis around the stock. We may already own the stock or if we don't own the stock, we've looked at it in the past and we feel that we've had a good handle on it but something's changed. What's changed? We need to understand what's going on. So we need to get some sort of handle in and obviously and often, there's often a lot of uncertainty around that particular scenario. So do we have a margin of safety around that level of uncertainty? So obviously the higher the uncertainty, the more of a margin of safety that we need.

But typically, I guess the way we like to look at things is now we look to own quality companies. So while some Fund Managers might look to sort of fish at the bottom of the barrel a little bit, we tend to be a little bit more, I guess circumspect on the quality of companies that we look at. So where we can get a quality company and it's on sale, the market's saying, "We've lost some faith in this company," and it's typically it's a short term issue or it's something that's only temporary in nature, if it's a good quality company and it's on sale and the market's saying, "We're giving this to you at a fair sale price," now we want to buy more of that stuff. That's near the sorts of opportunities that we're looking for in the market. So we're quite happy to sort of engage in that process and if something comes up and it's interesting and we get the conviction to own it, then we will.

James Marlay: So what are the traits that from your experience, generally result in a good turnaround experience?

Steve Johnson: My experience has been a new management team often helps, so I like to see some changes there at a board level and a management level and a bit of a --

James Marlay: Clearing of the decks?

Steve Johnson: Yeah. We're going to wipe the slate clean in here. We're going to focus on what we do well, and we're going to do that. Often, that comes with a bit of capital, so our most successful turnarounds, we've helped recapitalise the balance sheet, give the business some financial firepower to invest and to get on with life and to keep the customers happy as well. And then a bit of time, we often ... The liquidity is only there for us to get into some of these situations when everyone is panicking and it takes 12, 24 months before you start to see signs of the turnaround working in the market to respond to that.

They can be in the sin bin for a very long time. We've talked a lot about Service Stream (ASX: SSM) with you guys, but we owned that stock for three years and it just kept posting six monthly increases in earnings and the share price didn't budge for ages. So sometimes you just got to sit there and wait even when you can see that it's working out well.

James Marlay: Right, well, we've talked about the theory, let's put it into practice. I've asked each of you to prepare an idea for me. I don't know if it's going to be one that passes or doesn't pass. An example of a stock that's fallen out of favour that you think is a good turnaround or looks terminal.

Steve Johnson: I've picked one that I think might be unable to be resuscitated. I hope I'm wrong about it to be honest with you, but Retail Food Group (ASX: RFG) is one that we've had a really, really good look at and got pretty close too, but it doesn't tick many of those boxes that I talked about earlier. So the balance sheet does have a lot of debt on it and this is a business that is a business of brands rather than tangible assets.

So now there's more than 200 million of net debt there. Far more important for me, I think the products haven't been invested in for a very long period of time. They're tired and they're faded and they've lost market relevance, and I just worry that that can't be recovered in a very, very competitive, fast food, quick service market out there, and there's some great offerings in this country.

People are doing franchise really, really well in that space. You see businesses like Grilled and Guzman and there are businesses out there doing it really well. This company has bought brands and then they haven't invested a cent in them. And when I saw the turnaround plan and I came out and said, "We're going to set aside $2 million to invest in our brands.” That was the second I went “you guys need to add at least one zero and probably a few to that in terms of refreshing what you own here."

James Marlay: Yeah. Right. Marc, you've got something terminal or something that is going to turn around?

Marc Whittaker: I'm going to take the other tactic and give us something that --

Steve Johnson: Hope it's not Retail Food Group!

Marc Whittaker: No, this was new life, new life potentially. But our group is one that we really like, so the old Melbourne IT Group (ASX: ARQ). We had a little bit of that one prior to the half year update back in August disappointing results. A recent acquisition ... The business has two divisions: the Enterprise Services Division and Small and Medium Business Division.

There was disappointing up that in the SMB side of the business, and largely and arguably over consequence of management, probably being distracted, trying to do a couple of things or a couple of too many things at the same time, took their eye off the ball a little bit and as a consequence, we saw a delay in integrating this particular business in this part of the company.

The business isn't broken. We've got a great deal of respect for the CEO, Martin Mercer. He's done a really great job of transforming that business over the last three, four years. So it's really a new generation company and it's had a short term hiccup. In our view this is a short term hiccup, but if you see the share market reaction on the day of the result, a stock that was trading at $3 was suddenly worth $2 overnight literally, or probably a couple of days.

But looking at that opportunity and saying, "Well, what was the margin of safety?" What we could say was, well, the market was fully valuing the enterprise service businesses, but the rest of the businesses were zero apparently. And that valuation went from being made arguably a dollar a share to $0 a share overnight.

So for us is a case, "Well, let's have a look at this opportunity. What's changed?" And I think the strategic positioning of the company hadn't changed. The quality of management was still pretty good. I mean, there's a slight blemish state, but we were still quite happy with the way management we're conducting their affairs. That was pleasing.

It doesn't have any balance sheet risk. It's not at risk of collapsing. As I said, the moat around the businesses is, it wasn't that strong to begin with. It's in a competitive space but certainly its positioning in the market hasn't changed. It's still carrying on, it's still doing a good job.

So for us this was an opportunity again to the grab a great bargain on the market and if the market's happy to give us these sorts of stock that these sorts of processes where we're happy to take that in. It's a tech stock trading on 13 times and a 4% yield fully covered, fully franked as well. Go figure.

James Marlay: You can buy bombed out stocks, you've just got to go in and check those vital signs, and then be patient.