Shopping for stock market bargains can be highly profitable. A good turnaround buy can double or triple in value as quickly as the latest hot growth stock.
But you do need to be careful. Some stocks are priced for disaster because that's where they're heading.
Defence and aerospace group Cobham (LSE: COB) is a good example of a turnaround stock with an uncertain future. The group's shares rose by 2% this morning after it announced a £500m rights issue and a full-year loss of £847.9m.
Cobham's dividends will be suspended until at least the end of 2017, and the firm's board believes that "the delivery of a similar performance to that of 2016 in 2017 may be challenging". In other words, the group's results may be even worse this year.
A long list of problems
Things certainly seem bad. Chief executive David Lockwood said that weak management, poor financial controls, and a general loss of focus have affected the firm's financial and operational performance. Employee morale is low and staff turnover is high.
In addition to this, Mr Lockwood said that "the group may have misread the cycles within its markets ... making poorly timed acquisitions or integrating them poorly". This seems to point firmly at Cobham's acquisition spree under previous chief executive Bob Murphy.
A writedown in the value of these acquisitions accounted for most of the £573.8m impairment charge announced earlier this month.
Has Cobham hit rock bottom?
The firm's near-term outlook is uncertain. But Mr Lockwood said today that "all else being equal", the group should be able to deliver underlying operating margins 2%-3% higher than at present.
Today's results show an underlying operating margin of 11.6%. So a target margin of around 14% seems realistic. On current revenues of about £2bn, this would imply an underlying operating profit of about £280m. Based on the group's current market capitalisation of £2,050m, this level of profit looks potentially attractive.
However, this rosy outlook may take some time to achieve. We don't yet know how the group's £500m rights issue will be priced. I'm going to maintain a watching brief for now but I do believe that at some point this year, Cobham is likely to become an attractive turnaround buy.
I've bought this stock
One turnaround play I've already added to my portfolio is fashion retailer Next (LSE: NXT).
The high street chain's share price has fallen by 40% over the last year, but unlike Cobham it has a strong balance sheet and a very modest valuation. Another attraction is the firm's strong management and consistent cash generation.
Next currently trades on a forecast P/E of about nine. The board expects the company to generation surplus cash from operations of between £255m and £345m this year. Much of this will be returned to shareholders. The firm's guidance is for four quarterly special dividends of 45p per share, starting in May. That equates to a payout of 180p over a 12-month period, giving a prospective yield of 4.6%.
At under £40 per share, I believe Next is an attractive buy for both recovery and income. I plan to add to my holding over the next few months.
Are you targeting a £1m portfolio?
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Roland Head owns shares of Next. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.