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Buying “turnaround” stocks based on the past instead of the future is sure-fire way to destroy capital. For every Qantas Airways or BlueScope Steel, many more potential turnarounds destroy fresh capital on the way down, burning novice investors.
Those who anchor expectations to the past learn a painful lesson: a stock that traded at $10 and now trades at $2 is no longer the same company. Believing the stock will recapture its previous price high, because it once traded there, is folly.
Often, investors buy a fallen blue-chip too early. As the investment cliché goes, they ‘catch a falling knife’. The price chart resembles the pattern of a tombstone and they ride it all the way to the bottom when they should cut losses early and reallocate capital.
However, picking high-quality turnarounds – and buying them at the right price – can be rewarding. Think Newcrest Mining when it traded below $8 in late 2013 (now $22), even though it had long-life assets and looked badly oversold at its price trough.
Or Qantas. As some media outlets called for Qantas CEO Alan Joyce to resign, the airline drove an aggressive transformation program. Investors who bought the stock just above $1 in late 2013 watched it quadruple within three years. What a turnaround.
I look for a few key factors when choosing turnarounds. The first is balance-sheet strength. Turnarounds are risky enough without betting on companies that are loaded with debt and have no room for mistakes. Too many equity capital raisings dilute shareholders.
The second is companies with valuable industry positions. That is, those that can get back on track with better management and governance, or when industry headwinds start to turn. Such companies have capacity for high and rising Return on Equity.
The third factor is a re-rating catalyst. Buying turnaround stocks too early can be a portfolio killer. You buy a stock that has fallen from $5 to $1, believing the damage is done, only to watch it take years to recover and destroy further wealth along the way. There needs to be clear catalyst, such as lower fuel prices for Qantas, to re-rate the stock.
Excessive pessimism is the fourth factor. The market becomes “blinkered” about a company, only believing bad news and forgetting it is already factored into the valuation. Contrarians recognise that the pessimism, as was the case with Newcrest, is overdone.
A favourable charting pattern is the fifth factor. Although I favour fundamental analysis, combining it with technical analysis can help determine when to buy a turnaround. Often, the best time is after period of sideways consolidation on the chart, just as a new uptrend is unfolding.
The sixth factor is key: valuation. As with any investment, form a view on the company’s future earnings and valuation and compare it to the current price.  Examine consensus analyst forecasts for the turnaround company and its peers, and how those forecasts relate to the turnaround’s valuation history. 
Potential turnarounds worth further investigation
Brambles has claims as a potential turnaround. The pallets provider earlier this year surprised the market with a weak trading update, its stock falling 17 per cent on the news. 
Increased competition, cost pressures and customers’ pallet destocking weighed on the result. Brambles’ downgraded FY17 guidance for flat underlying profit growth disappointed. Also, the company said it would no longer provide medium-term performance targets.
For all the short-term challenges, Brambles has attractive assets. The company is the largest provider of pallets and reusable plastic crates (RPC) pool services. Its global scale provides competitive advantage, higher margins and an attractive return on capital invested.
Brambles has strong leverage to an upturn in the global economy and improving US retail conditions, and thus higher pallet demand. Wait for Brambles to form a base on its chart after heavy selling, before a slow recovery begins. 
Chart 1: Brambles Source: The Bull
Elsewhere, QBE Insurance Group rallied from almost $6 in September 2001 to $35 in August 2007, then tumbled to $9 in September 2016. Earnings downgrades in 2013 and 2014 followed a string of costly natural disasters earlier this decade.
QBE’s fall from grace led to media speculation in January that German insurance giant Allianz had the Australian insurer in its sights. A month later came the revelation that QBE CEO John Neal was docked $550,000 off his bonus for failing to notify the board of his relationship with his personal assistant. 
The news overshadowed QBE’s best full-year result in some years and early signs of a turnaround in insurance premiums and margins. Like Brambles, QBE has much to gain from a pickup in North America given it earns almost a third of its revenue there. 
The market is starting to talk about QBE as a turnaround idea. It has rallied from about $10 in November 2016 to $12.99. Rising US bond yields have been a short-term re-rating catalyst: higher yields boost QBE’s income from the investment of premiums in long-duration assets such as bonds. Further expected US rate rises this year are tailwinds for QBE.
Chart 2: QBE Insurance GroupSource: The Bull 
Longer term, QBE should benefit from an improving recovery in global insurance margins. The stock looks undervalued at the current price, but insurance cycles take years to play out and QBE’s recovery could take longer than expected. 

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Tony Featherstone is a former managing editor of BRW and Shares magazines. The information in this article should not be considered personal advice. The article has been prepared without considering your objectives, financial situation or needs. Before acting on the information in this article you should consider its appropriateness, regarding your objectives, financial situation and needs. Do further research of your own or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at March 16, 2017.