How to spot a 'turnaround stock'

A stock that's fallen on hard times is spurned by investors. But if it can get its act together, it can offer unbeatable value, says Tim Bennett. Here are three ways to spot a potential turnaround play.

The stockmarket is pretty brutal. When companies that come to the market in a blaze of glory start to underperform, investors lose interest and their share prices get hammered. But it's often a mistake to ignore these fallen angels'.

They may not attract the media spotlight too often, but when they get their act together they can offer the Holy Grail of good performance at a cheap price as a result. Here are three ways to spot a potential turnaround play.

Start with annual performance

As Mr Bearbull notes in Investors Chronicle, a good starting point is a firm's share price over one, two and five years. What you are looking for is evidence of a change in the share price trend and, ideally, an acceleration of that trend.

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Take a firm such as airline easyJet (LSE: EZJ). Over five years the share price is down around 14%. However, over the last two years it is up nearly 20% and over the past 12 months by almost 50%. So what's the story?

It's not a firm without its problems a key one being that it still makes losses (of £112m for the six months to the end of March compared to £153m a year earlier). On top of that, it is clearly a consumer-focused stock at a time when the average consumer is being squeezed by job insecurity, falling real wages and lower government spending.

Nonetheless, sales were up 16% for the same period and passenger numbers up 5%. How? Part of the answer lies in a clever pricing strategy. On popular routes where it faces stiff competition its low fares still secure bookings. And on more popular routes where planes are full, here's the thing it may market itself as no frills and low cost, but it's no longer that cheap.

For example, my wife's family frequently fly in and out of Gibraltar and have noticed how the cost of getting on what seems always to be a full flight has escalated, even if you book months ahead. This is annoying for us, but a very sound commercial strategy for easyJet on a route where it controls the best time slots.

For anyone planning to buy a share, one anecdote and three pieces of share-price data are a good starting point. But what else should you look for?

Check the moving averages are moving the right way

In terms of spotting a good entry point, the next thing I would look for is a bit of short-term share price momentum. One way to gauge this is with moving averages(see below). By comparing the 50-day moving average with the 200-day moving average you can get a feel for the market's current mood. After all, you don't want to pile into a stock, especially as a novice, just as it nosedives.

If the 50-day moving average has crossed the 200-day and both are still moving upwards then you have positive momentum. This makes it less likely that the one-year acceleration in the share price you noted earlier is a blip that's about to go into reverse. Beware a stock where the 50-day average is heading quickly down towards the 200-day (when it hits you get the dreaded death cross').

This tells you the stock is about to get hammered. For easyJet fans, the opposite, the golden cross', happened last year and so far the 50-day and 200-day averages are still on an upward path. Now for the final question do the fundamentals look strong enough?

Kick the tyres

Share-price movements and moving averages alone won't tell you two things that, as an investor, I want to know. First, is the stock cheap? Second, are the cash returns it generates improving?

The price/earnings (p/e) ratio isn't perfect. However, it is a rough and ready guide to value. There is no point in buying a turnaround play if the market has already overpriced it. For evidence of improving cash returns I favour cash flow per share. That's partly because with a loss-making business measures of returns based on profitability (such a return on capital employed) are less relevant. But I also like it as a ratio because cash is harder to manipulate than profits and in the current uncertain climate, cash is king.

So how does easyJet stack up on these measures? Its p/e ratio for 2012 is around nine and it's cash flow per share for the three years 2009, 2010, 2011 was 32p, 85p and 99p. So it makes the grade on both measures. Airlines stocks are not for everyone.

Due to rising oil prices and falling premium passenger numbers, many are worth avoiding. But with gaps opening up as local rivals fold, a clever pricing strategy and a focus on grabbing the more profitable slots from larger rivals, easyJet is well placed to fly through today's storms.

Moving averages

Let's say a stock closes at the following prices over five days 100p, 110p, 105p, 100p and 90p. The average of those prices is 100+110+105+100+90 all divided by five, or 101p. Now let's say on day six the stock closes at 80p. To calculate the new five-day average you drop the first reading and include the latest one. So now the average is 110+ 105+ 100+ 90+ 80, all divided by five, or 97p.

Moving averages can be calculated for any time period 50 days and 200 days are common as proxies for short- and medium-term share-price performance. Moving averages are useful because they reveal the underlying share price trend, undistorted by one-off share- price movements.

This article was originally published in MoneyWeek magazine issue number 591 on 1 June 2012, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.