Should investors be tempted by 'turnaround stocks'?

It was not long ago when a large portion of Indian companies were reeling under the pressure of mounting debt levels on their books. During the boom period - one that was expected to continue for many years to come - India Inc was on an expansion spree; increasing capacities and venturing into unrelated businesses. However, when the tide turned, it definitely did separate the wheat from the chaff. 

An economic slowdown coupled with rising interest rates led to cash flows being impacted, thereby making it difficult for companies to service or repay their debt obligations. The almost doubling of nonperforming asset (NPA) levels of public sector banks over two-year period ended 2012, gives an indication of the stress levels in the system. 

While there have been reports of the relationships between the bank executives and the businesses houses - and the lack of proper appraisal and due diligences - there are some opinions that the rising NPA levels are not entirely on account of crony capitalism, but also are on account of the economy slowing down, coupled with the government failing to carry out structural reforms and boost investments. But that's a story for another day. 

Amidst all of this, there would be few companies that would manage to ride the wave and survive the current tough times. And it seems that the process of improving their health positions has already begun. 

As reported by global rating agency S&P, the credit profiles of India Inc. is expected to improve given that companies are focusing towards reducing debt. This is happening by them selling off their assets and raising more capital through equity, while some are paying off debt through internal accruals i.e. by curbing their capex plans. Selling of non-core assets and divesting entire businesses is also something that is occurring. 

This kind of a trend is mainly being witnessed in infrastructure related companies. Being a beaten down sector (and for a while now), there have also been couple of reports of these being strong turnaround opportunities - as an investment strategy. And thus the potential of them being multi-baggers in the process! 

While a turnaround theme as a strategy may not be a bad approach, it would not be worth the effort in our view; and would most definitely be an aggressive approach. We believe that there are quite a lot of value traps that lurk in turnaround type stocks. Therefore, even if you buy these at huge discounts to their so called intrinsic values, chances are that the stock prices never reach those values. Given this situation of turnarounds seldom turning, we believe that one's efforts are much better devoted towards buying quality businesses at decent valuations. 

Investors would especially do well to study strength of the competitive advantages that good quality companies have. And for doing so, studying trends over longer periods - which cover various business cycles, would be essential.