Continue with the discussion about the appropriate time to buy an undervalued stock and the influence to the risk/return profile you would achieve. In my last article, I focused on the buying opportunities generated from the industry headwind. Today I will be looking at the buying opportunity from a company’s turnaround.
More often than not, stock price tumbling is, more or less, associated with internal problems with the company. Great companies usually find ways to steer out of the difficulties. The buying opportunity arises when the market is overreacting to the company’s problem. In other words, you think the difficulty that the company is confronted with is not as serious as the market consensus, and you have the strong conviction that the company will be bottomed out. The question is at what point you start a holding in the company’s turnaround process.
I won’t start a position if a company just starts to get into trouble because I don’t even know if there is a plan to turn it around. I won’t buy into the company if the management just lays out a plan either, as I don’t know if it works. I won’t buy the stock when all the troubles are over as everyone knows it and this is the selling point. My opinion is to start a holding when there are positive signs of improvement and during the troubling period, the company’s financials didn’t deteriorate so much. Obviously, the “so much” is a very subjective term. It depends on individual judgment. Let’s use Coach (COH, Financial) as an example to illustrate.
Coach’s management team launched a business transformation plan June last year to reinvigorate Coach’s brand that was tarnished in the last two to three years due to the overexpansion of factory outlets and promotional activities.
As we can see from Coach’s stock price chart in Figure 1, Coach’s stock price experienced three big plunges from January 2014 to July 2014. The first two share price plunges were being the time when Coach announced disappointing quarterly results, which prelude to a journey of business trouble. The third share price fall in June 2014 was the time when Coach announced the business transformation plan. The overall market didn’t buy in the plan and the share price tumbled further and hovered around $35 for the rest of 2014. Share price started to recover since 2015 on signs of business improvement from the transformation plan. However, last week when Coach announced the Q3 2015 result that disclosed 24% fall of the North American sales and earnings shrinking by 54%, the market become pessimistic again. And the share price retreated to the below $40 level.
Figure 1 Coach stock price 30/04/2013-04/05/2015
Now we may think that Coach remains a quality stock as the company still has robust financials even with the business headwind – in the past 10 quarters, Coach’s gross margins were above 68% except one quarter; operating margins were above 20% except two quarters; FCF margins were above 10% except two quarters. Coach’s ROE and ROIC had never dropped below 30% even in the business downturn in the last two years.
So when you should buy the stock? If you bought it when the share price first plunged in February 2014, say you bought at $52, you had negative return of 27% for the past year. If you bought it when the share price second plunged in May 2014, say $45, you had negative return of 15%. If you joined in the crowd, feeling buoyant of Coach’s prospect and bought it just before the Q3 2015 earnings release at $41 for example, you would have suffered 7% loss by now.
I would say now is a better chance to buy into Coach than the last two years as the Q3 2015 results showed the progress in the turnaround process, which gives us more positive signals. Specifically, the management team is delivering what they have planned a year ago in the brand transformation agenda. More important, the sequential results from those transformational efforts are encouraging. Investors can check the Q3 2015 results against the brand transformation plan in June 2014 for more details.
Admittedly, if you bought Coach below $35 in the anytime between June 2014 and December 2014, you may get a better compound annual return. Please refer to the below Figure 2 that gives you the CAGR you will achieve by buying at different time. The problem is you were taking higher risk when you bought it at the time with very low visibility of whether the transformation plan works. The issue is whether you would like to give up a fraction of the investment return to get a higher assurance of success. For me, I will be willing to do so as I believe protecting the capital from loss is paramount.
Figure 2
| Purchase Date | Purchase Price | Closing Date | Closing Price | CAGR |
| April 14 | 45 | June 18 | 55 | 5% |
| July 14 | 34 | June 18 | 55 | 13% |
| May 15 | 38 | June 18 | 55 | 9.7% |
To sum up, for value stock that is experiencing turnaround, we need to be patient. I personally think it would be better to buy when there are more firm signs that the business is able to turn around. Mr Market gives us plenty of time and opportunities to buy the stock. And there is no need to jump in early, worrying that you miss the best buying opportunity.
I would like to hear your thoughts on this issue.
