The science and art of turnarounds: a personal view
Turnarounds seldom turn – Warren Buffett
Do not kid yourself, all turnarounds are risky. And that risk is seldom bounded because any margin of safety based on liquidation value can quickly erode in the process. Turnarounds are the ultimate value trap. Peter Lynch, who had a history of successful turnaround investments, said it best:
Turnaround candidates have been battered, depressed, and often can barely drag themselves into Chapter 11. These aren’t slow growers, these are no growers. These aren’t cyclicals that rebound; these are potential fatalities – Peter Lynch, One Up on Wall Street
So why even take a look at turnarounds. Well, they have also some positive characteristics which can help to balance a portfolio and, if you are good at it, give it an extra kick:
- Performance is less related to the general market: specially interesting after a 50%+ bull run
- They have asymmetric returns, so when successful they can make up lost ground very quickly
The clue is to have a process to filter a thousand frogs to get to a prince. It has some echoes of venture capital investing.
Even Warren Buffett has invested in them. Always the riddle, while he makes clear cut statements about the dangers of turnarounds he is more pragmatic when opportunity arrives. The GEICO purchase in 1975, a period where good alternatives abounded, was undoubtedly a turnaround and a complicated one to boot.
I looked again at GEICO and was startled by what I saw after a few rule-of-thumb calculations about loss reserves. It was clear in a sixty-second examination that the company was far underreserved and the situation was getting worse –Warren Buffet, The Snowball
If you know anything about insurance, you know this a complex situation, even for a motor insurer with short tail risk. Buffett’s decision seems with traces of uncharacteristic sentimentalism. Hey, this was “the security I like best”. At the same time, GEICO was one of Buffett’s most successful investments and of course it was more than just sentimentalism:
This is risky. It could go completely out of business. But in insurance it’s very hard to get an edge, and they have an edge. If they got the right person in to run it, I think he could turn it around – Warren Buffett, The Snowball
In that simple paragraph Buffett narrows down the key issues on turnaround investing:
- The Science: We are not looking for survivors that recover somewhat out of a recession only to fall again in the next one. We are looking for outstanding winners like IBM in 1992, not unrepentant alcoholics like GM in 1982, or 1992, or 2002 or 2008.
- The Art: surviving depends on leadership, a good plan, momentum and luck. If you feel you lack the ability to read management and its progress you should probably avoid turnarounds.
I have read a lot of books about value investing. Not many of them even touch the issue of turnarounds. Probably because it is not considered really value investing.
On several postsI will try to give my personal view on this issue. I am not even sure what their content will be but I felt it was time to put some personal unstructured ideas in writing. And if in the process I can get feedback on particular investment ideas even better.