I’ve been investing for 20 years, and for the first half of my investing career, I repeatedly made the same mistake.

I’d buy beaten-up stocks, they’d barely budge for an extended period, and I’d finally give up and sell my investment for a modest gain or loss. Invariably, when I looked back on that stock a few years later, it had greatly appreciated in value — long after I had given up on it.#-ad_banner-#

Any time a stock falls sharply, it’s awfully tempting to jump in. We’re simply conditioned to pursue items when they are on sale, so a 50% or even 70% plunge can get our juices flowing.

You’re probably right that deep value exists when a stock has sold off sharply. But that doesn’t mean you should jump right in.

Turnarounds are one of the few types of stocks in which you can double or triple your money. But you should also know that some hoped-for turnarounds fail to ever take shape. That’s why you need to do a lot of homework, and show a lot of patience, before deciding to finally invest.

You could argue that if a stock finally rebounds several years later, you still made money. But that’s not the way you should look at it. The money tied up in a dead stock should have been deployed elsewhere in more timely stocks. That’s the only way to make real gains for a portfolio.  

The key is to find great turnaround stocks, and then watch and watch, until the time is right to pull the trigger. Here are some first principles.

1. Trust, but verify. Turnaround stocks can get a quick bounce from a management team that articulates a plan to aggressively improve aspects of the business model that are broken. However, there are also times when management finds that change doesn’t come as quickly as is hoped, if it comes at all.

This is why it pays to wait and see how those changes play out over several quarters. If the broken aspects of the business model indeed appear to be fixed, then you’ll be more assured that a turnaround is truly underway.

2. Watch the volume. The downside of investing in a beaten-down stock is that nobody else cares. Business may be on the mend, but if a stock no longer has a following among the Wall Street crowd, it becomes the proverbial tree falling in the forest.

That’s why I like to see trading volume perk up before getting involved. Rising volume in a stock means that a mutual fund or a Wall Street firm has taken fresh interest. Once they’ve built up a position in that stock, they’ll start to spread the word of the solid new investment they’ve found.

To be sure, stocks don’t rise unless a group of investors are focusing on them. Rising volume could also be a sign that a firm’s traders are building an inventory of shares — prior to an announcement that one of their analysts is following the stock. I like to see analysts talking up a stock, as it means the idea will be presented to all of the firm’s clients.

Conversely, stocks that have lost all coverage from analysts can have a hard time getting noticed.

3. Look for the breakout. We’d all like to find stocks when they are at their absolute lowest point. But I’ve learned over the years that trying to find the bottom is impossible, and as noted above, it can stay there for an extended period.

These days, I prefer to wait to see the stock post a small rebound, as it’s a sign that investors are finally starting to take notice. If you’re looking at a $10 stock that you think will go to $20, wait for it to increase to $12 — you’ll likely be closer to a meaningful upward move. If you buy at $10, you could be in for a very long wait, as I’ve learned the hard way.

4. Continually adjust your sights. Once you’ve bought into a turnaround stock and it’s starting to move higher, you’ll need to closely monitor events.

Determining a target price can be helpful with most stocks, but since many turnaround companies make dramatic changes to their business plans, it’s difficult to judge their performance.

For example, a wide range of moves to cut costs could boost profits for an extended stretch, making it unclear when the appropriate earnings and price-earnings ratio have been reached. In a similar vein, management’s efforts may yield operating margins that are higher than in past cycles thanks to cost cuts, so selling the turnaround stock when it returns to the point of past performance may be premature.

The nice thing about turnarounds is that they can run for an extended period as an increasing number of investors pile on. For example, when shoe maker Crocs (Nasdaq: CROX) appeared to finally turn the corner in early 2009, its shares rose from around $1.20 to more than $6 later that year.

A number of investors decided to lock in profits after capturing a big gain, but they ignored the potential for business to improve even more. Shares eventually moved into the upper teens before leveling off, and the early turnaround investors could be satisfied that they had bagged solid gains.

5. Have an exit strategy. Unfortunately, this is the downside of turnaround stocks. Clear objective exit points exist for most stocks, but not for turnarounds. Instead, it is a much more subjective process. Here are a few questions to ask when deciding whether or not the time is right to sell:

• Has the company’s string of improvements run its course?
• Has management lost the bullish tone it had maintained while the turnaround was underway?
• Is the stock now clearly more expensive than rivals on a price-earnings basis?
• Most importantly, have shares risen enough so that this holding now represents a large chunk of your portfolio?

I tend to sell turnaround stocks when they’ve come to represent more than 15% of my total portfolio, at least reducing their size to less than 10%.

Using Crocs again as an example, by the time the stock moved into the teens, it was no longer a well-kept secret, and a number of investors had piled in. At that point, it was no longer a turnaround story.

Risks to Consider: Trying to time the bottom on a stock is virtually impossible, so it’s more realistic to look for sound entry points, such as after a small bump in the price. Exit points can also be problematic with turnaround companies, so be prepared to recognize the warning signs of a faltering turnaround effort.

Action to Take –> When prospecting for turnaround candidates, investors should read between the lines of a company’s financial statements and management strategy.

This article first appeared on InvestingAnswers.com:
How To Invest In Turnaround Stocks