The appeal of investing in turnaround stocks is very compelling. Some companies look to revamp products to re-invigorate sales growth. Others find ways to slash expenses and unlock major profit-margin gains. Still, others look to clean up a debt-laden balance sheet, which is often a key reason for investors to disregard a stock.  No matter the plan, long-depressed shares can get a new life as these moves pay off.

A portfolio filled with turnaround candidates is a bad strategy. Even the best turnaround plans often go askew. Still, stocking your portfolio with one or two potential rebound candidates can help you beat the market averages. 

Here are three potential turnaround stocks I’m watching closely. Some of these ideas may fail to gain traction, but holding a basket of these should pay off.

1. Wendy’s (NYSE: WEN)
Roughly a month ago, I suggested this fast food operator’s new CEO, Emil Brolick, had a great industry track record and would soon articulate an impressive turnaround plan.

In late January, Brolick delivered a clear strategy for Wendy’s focused on improved breakfast results, spruced up stores and the addition of higher quality (and higher-priced) menu items. For Wall Street, this may be a hard plan to swallow. Wendy’s plans to spend heavily in 2012 to transform the business, so quarterly profits will likely remain weak. The fact that beef prices are expected to rise higher in the next few quarters is just another headwind.

But turnaround investors gauge a company’s plan by where it will likely be in 18-24 months. There’s no assurance that Brolick’s strategy will succeed, but even if he accomplishes only half of his goals, then investors will probably come to notice just how stunningly cheap this stock is compared with McDonald’s (NYSE: MCD) stock.

2. Nokia (NYSE: NOK)
This is a turnaround play I profiled just two weeks ago. At the time, I wrote the upcoming launch of pricier Lumia phones would likely really captivate investor interest. Well, the Lumia 900, the company’s flagship phone, is expected to make its debut at the end February at the Mobile World Congress in Barcelona. It will be curious to see how shares respond if tech reviewers give the phone high praise.

Of course the proof will be in the pudding. Will Nokia sell enough phones — and earn enough profits — to finally reverse a long losing streak? The current share price implies a great deal of skepticism, though these are the opportunities that offer the biggest upside. Nokia has much to prove, but a long-awaited turnaround may just take root in 2012. If Nokia can make a moderate dent in the Google (Nasdaq: GOOG)/Apple (Nasdaq: AAPL) hegemony of the smartphone market, then this stock could easily double.
 
3. Imperial Sugar (Nasdaq: IPSU)
The nation’s largest cane sugar refiner suffered a major blow in February 2008, when a key facility in Georgia exploded, killing 14 people. It took several years and a huge amount of cash to get the facility back on line, and though the company ultimately recouped the lost money through an insurance settlement, its operations have never fully recovered. 

Part of the company’s woes stemmed from the fact that contracts that were signed before the refinery explosion needed to be honored — at prices below current levels, crushing the company’s profit margins. More recently, Imperial Sugar has seen prices for its sugar-cane processing slump as beet sugar farmers flooded the market. Cheaper beet sugar means cheaper refined sugar, forcing Imperial Sugar to cut prices in response.

Despite the clear headwinds, shares managed to stay in a $10 to $20 trading range in subsequent periods. They actually rallied above $20 last summer as the pricing dynamics in the sugar market began to look much more favorable.

And then, the bottom fell out.

Imperial Sugar shocked investors by reporting an unexpected quarterly loss for the June 2011 quarter, citing increased competition from Mexican sugar growers. Expected gross margins of 10% fell all the way to -6%. For a company that only recently saw margins begin to rebound, this was the last straw for many investors. On Aug. 5, 2011, shares tumbled 59% to $9.41.

Pretty soon, investors realized that Imperial Sugar’s debt load would soon become a real problem — especially if profit margins didn’t rebound quickly. At the end of the June quarter, the company had just $300,000 in cash and $79 million in debt. The company would need to tap a credit line, but weak EBITDA meant Imperial Sugar would eventually trip covenants on that credit line.



As a final ignominious blow, the company asked for an extension to file its 10-K in December, giving the impression of utter chaos. Hamid Korshand, who had been closely following the stock for several years at BWS Financial, and previously assumed that the company’s assets were worth more than $20 a share, finally threw in the towel: “Like many, we have been surprised by the magnitude of everything gone wrong for the Company,” he wrote in a final note to clients.

Fast-forward to January 2012, when shares moved below $3. Investors largely assumed the company would need to file for bankruptcy. Yet shares have actually started to move back up in recent sessions, perhaps after a comment from CEO John Sheptor on a Jan. 9 conference call, when he said the company was exploring opportunities to improve liquidity, including potential further asset sales.

“We are in the late stages of exploring with our partner the potential sale of our interest in Wholesome Sweeteners to a third party,” he said a month later, on Feb. 9. The company’s 50% stake in this organic sugar marketer is likely worth at least $50 million, based on recent sales and profit trends. Shares popped above $4 on the news.
 
If successful, this gives the company even more time to clean up its balance sheet, perhaps with more asset sales. As noted above, NWS Financial’s Korshand assumed Imperial Sugar might be sitting on $20 a share worth of assets.  To be sure, the company’s weakened state gives it little financial leverage in discussions with potential buyers. Assuming the assets are worth half as much as Korshand thought, then shares would still be worth close to $10. That’s still almost 200% above the stock’s current level.

Risks to Consider: Turnarounds don’t always play out according to plan. In the case of Wendy’s and Nokia, this likely means shares would languish at current levels. For Imperial Sugar, an inability to turn things around could ultimately render its stock worthless.

Action to Take –>  Turnarounds are slow to be appreciated by Wall Street. So for a company such as Wendy’s or Nokia, you may actually see business start to improve before the share price responds. In this case, now is a fine time to start researching these companies, looking for tangible signs of improvement before you buy.

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