Did you know that it is sometimes possible to make money by owning stock of low-performing companies? To be more specific, it is occasionally possible to generate significant investment returns by purchasing the least attractive stock in a particular sector or industry—if you have an educated idea that it is due for a turnaround.
Learn why it might be a good idea to invest in a low-performing company, when you might be able to do it and how the strategy works.
What Is A Low-Performing Company?
While they might sound like investments to stay away from, low-performing companies are not companies with terrible management or financial practices. Not all companies can be the best. In fact, most companies will never be the "best investment," but it doesn't mean they aren't worth investing in.
A low-performing company (from an investor's perspective) is performing financially at a lower level than other businesses in the same industry and market. It might not give returns, and it might not have shown much growth in the past.
The business might be in a highly competitive market with high barriers of entry that make it challenging to grow, such as the oil market or other commodities. This can give it the appearance of performing low.
Identifying A Low-Performing Company
To find a company that might turn around, it helps to have conducted some research beforehand. If you were interested in commodities such as oil, you might begin by analyzing the industry first. The oil industry has very high natural barriers to entry—almost monopolistic—such as set-up costs, control or access to raw materials and economies of scale.
It also has many well-known brands with large market capitalization that a not-so-well-established company will have difficulty breaking into. More money will need to be spent by a lower-performing oil company to compete with higher market-cap rivals. Higher operating costs and lower profits will generally keep a newcomer on the low-cap end.
For example, imagine it is the late 1990’s, and crude oil is $10 per barrel. You have some spare capital with which you wish to speculate; money outside of your core portfolio that you are willing to risk and do not need to survive.
It is your belief (because you've been following world developments, commodity prices, and monitoring oil supply and demand) that oil will soon skyrocket to $30 per barrel, and you’d like to find a way to take advantage of your hunch.
Oil prices depend on global supply and demand, weather and geopolitical events. Depending on the commodity, others are also affected by these factors. It helps to have an understanding of the effects events have on the investment you're considering.
If all other global and economic circumstances fall into place as you predict, you might see a Cinderella story unfold:
- Company A is a highly profitable oil business. Crude is currently $10 per barrel, and its exploration and other costs are $6 per barrel, leaving a $4 per barrel profit.
- Company B is making a profit, but much lower. It has exploration and other expenses of $9 per barrel, leaving only $1 per barrel in profit at the current crude price of $10 per barrel.
Now, imagine that crude skyrockets to $30 per barrel. Here are the numbers for each company:
- Company A makes $24 per barrel in profit. ($30 per barrel crude price - $6 in expenses = $24 profit).
- Company B makes $21 per barrel in profit ($30 per barrel crude price - $9 in expenses = $21).
Company A makes more money in an absolute sense, and profits increased 500% from $4 per barrel to $24. However, Company B increased profits by 2,000%. Before the price increase, Company A probably had a higher price-to-earnings ratio because it made more money, and therefore had a higher stock price.
With a lower stock price originally, Company B is suddenly more attractive to investors because of the profit explosion. The company might then experience something known as a multiple expansion where the price-to-earnings ratio increases. The result would be the stock price of Company B increasing exponentially more than the stock price of Company A.
Company A is the better business after the price change, but Company B is the better stock.
How This Strategy Works
What happened in the two-company example is that Company A experienced a lower increase in stock performance than Company B. The mathematics behind the phenomenon isn't too complicated—B's earnings jumped significantly more than A's, and their stock price followed suit. The stockholders of B also experienced a flood of value increase.
Because of its high fixed expenses, it has high operating leverage. Operating leverage refers to a business' fixed costs as a percentage of its total costs. If it has a higher fixed cost percentage, it is referred to as having high operating leverage.
This strategy generally works for stocks of companies with high operating leverage. However, it is not failsafe or without risk. High operating leverage companies are generally in volatile markets like commodities.
Companies with high operating leverage tend to be found in either:
- Asset-intensive industries: Airlines and steel mills are quintessential examples. When things get bad, they tend to fall all over themselves on the race to bankruptcy court, wiping out investors along the way. When things are good, the share prices explode upward, making a lot of people (often temporarily) rich, or
- Commodity-dependent industries: Copper producers, gold miners, oil exploration companies tend to have huge fluctuations in revenue. Generally, these variations result in wild profitability swings because the fixed costs do not adjust to the market value of the commodity.
When Company B experienced a rise in profits, it significantly increased its ability to pay fixed costs and retain earnings or distribute dividends. Companies with high operating leverage generally have to maintain high levels of sales or profits.
The key to making the strategy work is to find a company with high operating leverage that is solidly performing somewhat below the industry. Through analysis, determine a time when the company is likely to experience growth, and invest.