The turnaround checklist

In the fairy tale, The Frog Prince, a magical kiss transforms a cursed frog into a handsome prince. In a similar vein, Warren Buffett, in his inimitable style, describes acquisition-hungry CEOs as being “mesmerized by their childhood reading of the frog-kissing princess. Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations”. Buffett might as well have been talking about promised corporate turnaround stories.

The legendary fund manager Anthony Bolton, in his book Investing Against the Tide: Lessons From a Life Running Money, has devoted a chapter to “My favourite type of share”. Expectedly, these are turnaround stocks that he invested in before the market fully appreciated the change. Successful turnaround stories always make for interesting reading, such as Steve Jobs’ return to build Apple into one of the world’s greatest corporations or Lee Iacocca’s battle for Chrysler’s survival. Straightforward as it may sound, as portfolio managers we can assure you that predicting such winners is far from easy. Stock investors stand to reap outsized returns if they get it right but such opportunities are few and far between. Many stocks are pitched as turnaround stories but the experience is that maybe one in ten actually live up to the hype. The real skill then is to find the prince without having to kiss a hundred frogs.

From our toad-kissing experiences, there have been certain signposts that have helped us improve our odds of success. In most cases, turnarounds are associated with new management teams or some sort of leadership change. As portfolio managers, we assign a high weightage to face-to-face meetings with the CEO and the management team. Listening to them to gain an understanding of management strategy is especially important in these situations. Here is the turnaround checklist that we carry to these meetings.

• Diagnosis: What’s working, what needs to be fixed? CEOs who attribute all their woes to the macro-economic situation or those who want to overhaul the entire organizational structures and processes haven’t adequately diagnosed the problem. The idea is to look for surgeons with scalpels rather than butchers with knives.

• Focus: Investors cannot formulate business strategy but need to understand how managements think about it. Most of us are not good chefs but we can tell good food from bad. Specifically, look for a black list of products, services or regions that are clearly off the table in medium-term business plans. Exclusion makes the current focus sharper. Again, management teams that are not able to clearly lay down their black-lists should dampen enthusiasm.

• The to-do list: A peek at the CEO’s to-do list is vital. It has to be precise. Too vague or long a list is again a symptom of insufficient diagnosis. Also look for signs of food that has been produced in a factory—a consulting company’s standard language and slide deck. Be sceptical of management teams who tell you that they have hired an army of consultants to tell them how to engineer the turnaround.

• Competition awareness: Turnaround stories typically lag their peers on most business metrics. Look for an analysis of strengths and weaknesses of competitors. Neither competition-awed nor competition-dismissive managements are likely to succeed. Seek out competition-aware management teams.

• History: Sift through the performance history of key members of the management team in their past organizations or divisions within the company. People and their management styles seldom change.

• Measuring yardstick: It is important that the CEO is able to clearly articulate how markets should measure the team’s success. A tangible, quantifiable set of metrics acts as a barometer to measure the promised turnaround. Often, CEOs fumble with this—either the metrics are woolly such as “significant stakeholder value addition” or they have aspirational targets such as a revenue number without a timeline. Time-bound targets that are easy to measure such as return on equity, revenue growth, operating margins, free cash generation, debt reduction, etc., make the strategy credible.

• Follow up: In many cases, metrics may fall short of the originally envisaged trajectory but a good CEO can quickly do an attribution analysis of what helped and what hurt the turnaround journey. In a dynamic world, it is almost impossible to achieve all targets with precision and we have seldom sold stocks just because they were not able to meet the promised metrics. What we look for in the follow up meetings is a clear understanding of the headwinds that have caused a deviation from the original plan and the need, if at all, for a course correction. Shifting goal-posts, without good reason, however are a cause for worry.

The reason for writing this now is that in the current economic gloom one sees a sense of despondency even with stock-picking. In these testing times, investors need to remind themselves of their past successes to gather courage. Despite slowing growth, India will still have a double-digit nominal gross domestic product (GDP) growth and there will be sectors and stocks that will grow faster than nominal GDP. In a growth-scarce world, if one is able to find these oasis of sustainable, profitable growth they can well prove to be worth their weight in gold.

Amay Hattangadi and Swanand Kelkar are portfolio managers with Morgan Stanley Investment Management. These are their personal views.