Key takeaways:

• Turnaround stocks are difficult to spot - investors require patience, but the potential upside can be significant if the business succeeds

• Investors should look for improvements like a change in business strategy, a turnaround in sales, or cost-cutting initiatives

• Stocks like Apple, IBM, and BP are examples of former turnaround stocks

A turnaround stock is a company that has encountered difficulties of some nature. It has turned the corner, or is about to turn the corner, as its prospects improve.  

Beaten-down companies are easy to spot. You can simply filter stocks by performance and see those that have lost the highest market cap over a period of time. 

However, finding turnaround stocks is far more tricky. Yes, they typically trade at low valuations, but this is because of the headwinds they face. It is also partly attributable to the low confidence in their outlooks among investors. Not only is there no guarantee that a company rejuvenation will go to plan, but the root causes of the company decline can always reappear. Investors should be prepared for a potentially long and arduous path if investing in turnaround stocks. With that said, the rewards can be like finding treasure. The trick is to identify changes that support a re-rating in a stock valuation. To do this, keep an eye out for any of these signs. 

Changes to Management or the Business Strategy

In 2015, shares in Australia's leading wholesale distribution and marketing company, Metcash (ASX: MTS), were in the doldrums. During the immediate years prior, the company overstretched itself by acquiring controlling interests in non-core hardware and automotive businesses at a time where cut-price Aldi was just starting to pose a threat to Woolworths (ASX: WOW) and Coles (ASX: COL).

Earnings were hit hard. Shorters increased their bets against the company. But following a strategic review, management laid out a turnaround plan. At first, doubters looked correct, as the plan, first rolled out in early 2014, took time to gain steam. But after about 18 months, there was traction as the company reoriented its focus towards grocery operations.

Management focused on consolidating the company network, improving its supply chain, and investing in infrastructure for the long-term. By FY16, profits were already higher than before the turnaround plan was implemented. The rest, as they say, is history. 

Metcash is an example of how changes to business strategy can help drive a turnaround, and a material re-rating in a stock. It is a similar proposition for beaten-down companies that change management, since this often entails a strategic pivot as well. Once again, however, patience is everything. Above all else, the turnaround plan needs to be viable.

Sales Turnaround After a Period of Decline

In most instances, a company that sees its sales decline over a period of time will need extensive time to implement changes to restore growth. However, sometimes things may change quickly to reverse sales. Once sales start to turnaround following a period of decline, that generally improves the prospects for earnings growth. In theory, this should support a higher share price. 

Some companies may even choose to reinvest earnings to improve future growth opportunities, effectively creating a momentum cycle.

New product pipelines are one of the most effective ways that companies can kickstart a turnaround. Even Apple (NASDAQ: AAPL) managed to achieve this feat in 2001, after a period of several years where its revenue had trended lower. Along came the iPod, which in many ways turned out to be a game-changer in reigniting sales growth.Although it has underperformed in more recent times, IBM (NYSE: IBM) achieved a sales turnaround back in the 1990s. It achieved this by expanding its suite of products and services. As a result, revenue soared from US$64 billion in 1994, to over US$88 billion by 1999.

Sales may also reverse course if there are changes in the legal or regulatory space, competition enters or exits the market, or the supply and demand equilibrium shifts.

Cost-Cutting for a Leaner' Business

For mature companies, the idea of suddenly growing sales is difficult. It may even be an unrealistic proposition, or outside of a company's control, as is often the case with commodities exporters.

However, companies can still generate returns for shareholders by driving operational efficiencies. One of the ways to achieve this is through cost-cutting initiatives. 

More often than not, companies seek to do this by addressing the biggest expenses on their balance sheets - labour costs. A number of companies have implemented this rather successfully over the years.

For example, take Delta Airlines (NYSE: DAL). The US airline was hit hard in the years after the September 11 terrorist attacks. It declared bankruptcy in 2005, but when it emerged from bankruptcy just 18 months later, it had tightened up its expenses. 

Not only was Delta a leaner' business with a reduced headcount, but over the ensuing years it embarked on several initiatives. The company merged with a peer, formed alliances into foreign markets, and even bought its own oil refinery in order to manage long-term expenses associated with its biggest cost input - fuel.

Other examples include Booking Holdings (NASDAQ: BKNG), which cut costs after the dot-com crash, and personal care brand Kimberly-Clark (NYSE: KMB). In 2015, KMB slashed 6,000 jobs and closed a swathe of its plants to save hundreds of millions of dollars in annual expenses.

Investing in Turnaround Stocks

It is estimated that just 20% of business turnarounds succeed, which suggests investing in these companies is risky and uncertain. However, some of today most well known businesses like BP (NYSE: BP) were on the ropes at some stage. Some wouldn't be where they are today if it weren't for their turnaround stories. Investors who stuck by the turnaround, through thick and thin, have been rewarded handsomely. 

In any case, it is clear that Investors looking for turnaround stocks need to exercise great patience and conviction. Whether it be a turnaround in sales, a change in business strategy, or cost-cutting initiatives, these are just some of the ways a turnaround may take place, and even after all that, the macro environment sometimes holds the largest sway.