Investing in a successful turnaround can be very satisfying as it often allows you to lock in a high yield and enjoy generous capital gains.
As a value investor, I'm often tempted by turnaround stocks if I feel that the company's cash flow and balance sheet are strong enough to allow a recovery.
A classic contrarian buy?
One of the more extreme situations in the market at the moment is logistics specialist Connect Group (LSE: CNCT). This Swindon-based firm's main business is the delivery of newspapers to shops each morning. It also owns parcel firm Tuffnells.
Connect shares have slumped from 143p to 66p over the last year and recently crashed 28% in one day following a profit warning.
I held the shares before the profit warning and decided to average down afterwards. Although the expected shortfall in profits this year is disappointing, the fall in the share price has been much greater than the expected shortfall in profits.
This business is still profitable and highly cash generative. I believe this should give management the breathing space they need to develop new sources of growth.
Is a 14% yield possible?
Anything connected to the traditional newspaper business is extremely out of favour at the moment. Valuations are very depressed -- Connect stock currently trades on a forecast P/E of 4.7, despite having cut its debt levels significantly last year.
This ultra-low valuation means that the group's forecast dividend yield has risen to more than 14%. That's clearly a signal that the market expects profits to fall, with the dividend likely to be cut or suspended.
I agree that further problems are quite likely. I wouldn't take a large position in this stock. But if management can stabilise profits and find a route back to modest growth, then the shares could re-rate strongly, providing attractive gains from current levels.
Should you buy this retailer?
It's no secret that high street retailers are finding things tough. A good example is men's formalwear specialist Moss Bros Group (LSE: MOSB).
This company warned in January that full-year profits were likely to be "slightly below current market expectations". The shares have since fallen by 22%, even though this is only expected to be a small miss.
What's worrying the market, in my view, is that Moss Bros sales appear to have fallen off a cliff in December. The company said that like-for-like sales rose by 1.2% from August to November, but then fell by 8% in December.
That's a remarkable decline. It suggests to me that there's some underlying problem. No information was provided on what this might be, but management did say it also expects 2018/19 profits to be lower than anticipated.
I'm staying away
Moss Bros's saving grace is that it has a strong balance sheet. Net cash was £21m at the end of July, which is equivalent to around 30% of the group's £70m market cap. We don't know how this may have changed during the second half, but this cash should mean that management can afford to invest in the business without financial constraints.
However, men's fashion is always a difficult area. Until the company provides more information about the problems it's facing and how they will be addressed, I plan to stay away from this stock.
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Roland Head owns shares of Connect Group. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.