In business as in life, a healthy sense of self-awareness is often the first step to meaningful change. Companies that are conscious of their flaws and eager to address the root problems offer a source of solid return potential for equity investors who identify the turnaround stories early.

Struggling companies are a good place to look for undervalued stocks and unappreciated return potential. These days, business turnaround stories offer another benefit: companies zeroed in on fixing their own weaknesses stand a better chance of increasing margins and cash flows irrespective of the highly uncertain surrounding environment, over which they have no control.

How to Identify Turnaround Stories

Investors searching for new equity opportunities might be deterred by underperforming companies. But not all business challenges are the same. Some companies are victims of volatile macroeconomic forces. Others are battling changing industry dynamics that left them strategically disadvantaged. In these cases, even a star-studded management team might be unable to overcome the headwinds.

In contrast, companies that are nursing self-inflicted injuries may be well placed to heal. Perhaps a misguided business strategy led the company in the wrong direction or an uninspiring management team made bad decisions. Ironically, companies like these actually deserve closer attention because they have the power to rectify mistakes by adjusting their business models or refining operations.

Consider the consumer sector. Many retailers have struggled to strike the right balance of physical stores in an increasingly digital world. Maintaining a strategically appropriate physical presence while properly positioning brands is the key to productivity. Hugo Boss, the German clothing and luxury brand, stumbled on both fronts. Store profitability was hampered by focusing too much on top-line sales instead of the bottom line amid a muddling of its two main brands.

What was the fix? First, the company announced a new CEO from rival Tommy Hilfiger in June 2020, who recognized the problems. Then, it made a clear demarcation between its two brands: Hugo, an entry price point for younger consumers, and Boss, a premium label for an older demographic. At the same time, the company shrunk its physical store presence, leading to a reduction in store costs as a percent of sales. Through self-help, Hugo Boss has improved productivity to lift profit margins.

Banking on Efficiency

Margin pressure has been particularly painful for banks. With interest rates so low, it’s hard to boost profits from lending. Net interest margins—the difference between the interest a bank pays to borrow and the interest it collects from lending—have been severely compressed.

But even in this environment, some banks can sharpen their edge. Turnaround candidates can be found by looking at comparative cost-income ratios to see which lenders can generate improvements from within. The Bank of Ireland, for example, has a much higher cost-income ratio than its competitors. After bringing in a new management team in late 2017, the lender acknowledged its internal weaknesses. With a clear playbook focused on actions including refreshing its IT infrastructure and shortening processes for approving loans and mortgages, the Bank of Ireland has been able to exceed expectations of trimming its cost base. As a result, it has demonstrated a decisive shift in the business, even as revenues struggled from the pandemic’s effects.

Rehabilitating a Healthcare Business

Well before the pandemic, Getinge was a victim of its own mismanagement. The Swedish medical technology company was burdened by a collection of small acquisitions that needed to be consolidated. With a range of medical devices used by hospitals around the world, the company should have benefited from a stable flow of revenues that is typical in an industry where equipment users are very reluctant to change suppliers.

Here too, new management was the catalyst for change. By consolidating factories and sharpening sales productivity, Getinge was able to solidify its business and benefit from the consistent demand for medical devices. And the company’s line of respirators received an unexpected boost in demand given the needs of hospitals to treat COVID-19 patients.

What do all these stories have in common? First, each company had a proactive management team that didn’t try to blame external events or sugarcoat business blunders; consistent messaging from management and the board signaled to investors that real change was afoot. Second, each company could nurse itself back to health by improving operating leverage—getting more productivity out of existing assets—so they didn’t depend on sales growth to recover. And third, the recovery plans could bring about change even in a more challenging macroeconomic environment.

Of course, with the pandemic still inflicting material challenges to the global economic recovery, companies of all types will face many hurdles to long-term growth. Turnaround stories offer paths to profitability gains that should withstand the test of time and deliver tangible results for investors.

Andrew Birse is Portfolio Manager—European Value Equities at AB

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time.

References to specific securities are presented to illustrate the application of our investment philosophy only and are not to be considered recommendations by AB. The specific securities identified and described do not represent all of the securities purchased, sold or recommended for the portfolio, and it should not be assumed that investments in the securities identified were or will be profitable.