Four classic 'recovery' stocks for the bold

published 26 March 2010

I like to identify companies that are young, innovative and ambitious. They are largely unknown. They carry no baggage of past failures, and no disappointed hopes.

But penny shares come in different guises. And today I want to talk about one of an altogether different stamp: the Real Good Food Company (LSE:RGD). This is a classic 'recovery' stock.

At the start of this year you could have bought shares in the Real Good Food Company for about 4.5p each. Today they trade at 14p. You could have tripled your money in less than three months.

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But business was not always so buoyant. Over the past decade the Real Good Food Company has been to corporate hell and back.

A few years ago I met the group's founder and chief executive Pieter Tott at his office near Tower Bridge

A former financier, Tott fancied his chances of building a food group. He quickly assembled a group of companies in the food sector covering fish, baking, baking ingredients and sugar.

Frankly, I did not feel that any of these companies were especially attractive in their own right. Grouping them under one corporate umbrella did not make them appear any more so. So at the time I gave it a wide berth.

A Real Bad deal for Napier shareholders

I know that a conglomerate of this sort tends to be judged by its weakest member.

The City expects the group to fire on all cylinders. But if one of them starts to choke they condemn the lot.

The Real Good Food Company proved to be a good one to avoid. The last five years has been a corporate horror story. The fish business was sold. The other businesses struggled. Then came profit warnings, tense negotiations with bankers, resigning directors and a plunging share price.

Rock-bottom came in summer of 2005. This when Real Good Food acquired the well-established sugar trader Napier Brown for £68m.

Rather than demanding cash of this amount, Napier Brown's shareholders happily accepted shares in Real Good Food, which at the time were worth 135p. They have since lost 90% of their value. How must they be feeling?

When a company falls from grace like this, the fallout is nasty. City shareholders want out. Bankers have the management over a barrel. Customers become wary. New and perhaps essential investment is cancelled. The accounts become muddied by restructuring charges. From the outside it looks a mess. And on the inside it is even worse.

And yet the corporate animal is hard to kill off altogether. Despite such hardships, some companies do have what it takes to turn things around.

Management rolls up its sleeves, cuts costs, begs or borrows some much-needed finance. Somehow keeps the show on the road.

Investors brave enough to get in when all looks lost can make great returns. So how do you unearth a good recovery play?

A clear sign that an ailing company can redeem itself

For me, there's one clear sign that a company is going to be able to pull itself back from the brink and is going to repay the brave investor's gamble. This is turnover. Real Good Food is a classic case.

A few weeks ago the company was valued at just £2m. And yet its annual sales are over £200m.

Admittedly much of this is from low-margin sugar trading. But the important thing is that this company's vital signs are very good. It is making sales. It has customers. And it has cash flowing through its accounts each day.

So with a real emphasis on profit margins and cash management it should be possible to stay afloat and keep the bankers happy.

Judging by a positive trading statement last month, this is just what Real Good Food is managing to achieve.

It may have a long way to go before the share price gets close to the dizzy peaks of 2005, but Real Good Food has amply demonstrated its staying power.

So where else should we be looking for likely penny share recovery plays? My stock screen throws up a handful of interesting names. In each case it's the company's turnover we're interested in.

Foreign exchange broker Baydonhill (LSE:BHL) is valued at just £3m. And yet the company recorded a turnover in the last six months alone of £300m.

What about communications technology provider Redstone (LSE:RED). It is also valued at £3m, but announced £49m of revenue in its last half-year.

There's also SDI Group (LSE:SDI), which supplies shelving for warehouses. This company is valued at £4m. Yet it announced revenues of £23m in its interim results.

And finally there's Webis (LSE:WEB). This online gaming group is valued at just £4m yet it recorded turnover of £56m in its last half-year.

These companies all have at least one of the characteristics of a good recovery stock.

Whether they ever get out of the recovery ward, time will tell. But with financial confidence rising as the stock market continues to tick up, this is a promising time for recovery stock punters. And if you're one of them, there's one way you can really boost your chances of making big returns.

'Advance scouting': the best chance to secure big recovery play gains

The key to making the biggest returns from a recovery play is spotting when the recovery announcement is going to happen. I won't disguise it, this is a high-risk strategy. But if you get it right, you could be enjoying triple digit gains on your investment without having to wait long at all...

I have a technique for picking penny share stocks that I call 'Advance Scouting'. What's this all about? Simple. I look for companies who I think are about to release big, company-making news... and make sure I invest in them early for the biggest potential returns.

And this technique is not just limited to recovery stocks. It applies to every sector of the penny share market. This article was written by Tom Bulford, and was taken from his free twice-weekly email:

The Penny Sleuth

Tom worked as a fund manager in the City of London and in Hong Kong for over 20 years. As a director with Schroder Investment Management International he was responsible for £2 billion of foreign clients' money, and launched what became Argentina's largest mutual fund. Now working from his home in Oxfordshire, Tom Bulford helps private investors with his premium tipping newsletter, Red Hot Biotech Alert.