Some of the best investments are made in fear by investors who aren't sure if they're taking a desperately risky gamble or making a very good investment. This is because the rewards for identifying a potential winner early are high.
But the chance that such an investment will fail is also high. Usually this sort of investment is in a cyclical or some other sort of turnaround, which means that the risk of mistiming the cycle is higher if one is entering early. A quarter of better performance by a loss-making stock may be encouraging, but it could also be a false dawn.
Typically, a turnaround or a cycle that is bottoming, offers pretty good chances of being a multi-bagger with three-digit or even four-digit returns. Historically, such stocks can offer the same sort of returns as 'good' IPOs. Turnarounds are usually also easier to identify than killer IPOs simply because listed stocks have more reliable trackrecords than unlisted ones. If a business has been running for five or six years and it has a proven history of bouncing back from cyclical bottoms, then it is more reliable than a possibly-underpriced IPO.
On the rare occasions when an IPO is evidently underpriced, it is usually oversubscribed as well, so it's likely to be listed at the top of the price band and allotment may literally be a lottery. Turnarounds are more convenient investments on such criteria as well. If you find a turnaround early, there is no rush to get into the stock and you can buy as much as you want, at more or less the prices you are targeting.
One problem with early entry to a potential turnaround is of course, the fear that the apparent change will not be sustained. Another is that it may take a long time for the market at large to figure out that the business has indeed changed trajectory and the stock price won't move up until that recognition occurs.
How does one cut down on those risks? One way is to try and wait for at least one quarter of genuinely improved performance. Don't rely purely on anecdotal evidence or 'khabar' in the case of a company with accumulated losses on the balance sheet. That falls genuinely into the realm of speculation - you might make money, but it would be a short-term trade rather than a long-term investment with multi-bagger potential. Also try and get a sense of sustainability. For example, strong consumer sentiment during the festive season could spark off a good quarter for consumer durables. How sustainable will the sentiment be? Try and assess that.
Another way to cut down risk is a hard look at price and valuations. This amounts to setting long-term stop losses. That is say, you have bought a potential turnaround at say, a price of Rs 20 per share. If the stock saw a 52-week low of say, Rs 16, you could assume that a price dipping below that benchmark would mean your investment had turned sour. You might decide to follow a two-pronged strategy: buy and average down if the stock trades between 16-20; start getting rid of it below Rs 15. Obviously you would review your assessments at the next quarterly results on the basis of the usual fundamental criteria - growth in sales, profitability, margins, lower debt, etc.
There are plenty of potential turnarounds in the stock market at present. Most stocks have seen falling margins, quarter-on-quarter, for a year or more. However, price is uncomfortably high at the moment. The flood of FII liquidity has pushed stock valuations higher than one would like over the last three months. This could mean there is more of a downside if the market does go into a tailspin again. These prices and valuations would be unsustainable if the FII attitude changed. If growth stabilises at current levels, the associated price-to-earnings valuations would be difficult to justify.
The Q2 2012-13 results have been more or less in-line with consensus expectations. There have been some upside surprises, but also some downside surprises. If the economic cycle has genuinely bottomed, there should be a sharp pickup in the present quarter (Q3) and further acceleration in growth in Q4.
The RBI decision to stand pat on interest rates means that borrowing costs won't ease for a couple of months. Banks, especially PSU banks, will remain stressed due to the high level of NPAs, and the greater provisioning for restructuring will reduce credit growth. Buying into such an environment should be very selective.