COMMENT
The Next 12,100% Return

Companies recovering from mishaps can make for wonderful investments. The classic example I guess is Next (LSE: NXT). Various problems brought the fashion retailer to its knees in the early Nineties. But had you spotted the turnaround potential and bought the shares at their 12.5p low in 1991, you'd have since earned a 12,100% return - that is, made 121 times your money - excluding some very sizeable dividends!

Within Champion Shares -- the Fool's brand new investment service -- I'll be revealing many of the best money-making opportunities in the stock market. Among them will be some very promising 'recovery plays'. Businesses experiencing trouble, however, are not for the fainthearted. For every Next I can mention, there are countless others that have struggled all the way to bankruptcy.

As such, I've developed a checklist for screening the turnaround winners from the serial disappointers. Here's my five-step guide for pinpointing Champion Shares for recovery.

1. Solid balance sheet: This is important. If a company has too much debt and too little profit, there's a good chance of incurring every investor's worst nightmare: a 100% loss. If the balance sheet borrowings appear worrying, I'm inclined to wait for a debt-for-equity swap, a disposal, a rights issue or anything else to come along and shore up the finances. Usually that means missing out on the first part of a share price recovery, but it also decreases the chances of the company going bust!

2. Decent products: Focusing on struggling companies that enjoy a decent underlying product helps me in two ways. First, the company is more likely to continue selling the product and generate cash (i.e. survive). Second, there's always a chance a rival may want the product for itself and make a bid. The worst situation to be in is holding a troubled company whose product is easily imitated. Nervous customers and suppliers may jump ship and push the company into deeper trouble.

3. One-off problems: Something I really like with my recovery shares are clear one-off, solvable or external problems - they're easier to rectify. Of particular interest also are companies experiencing good sales growth but have warned of costs coming in higher than expected. In my view, cutting costs is much easier to do than generating additional sales. On the other hand, firms warning on profits following a turnover contraction can be a minefield - unless the company has a proven record of surviving previous industry cycles.

4. Fresh management: I have often seen new bosses act as a catalyst for recovery. They're not hindered by the emotional baggage of the previous (usually, long-time) chief exec and find it much easier to slaughter 'sacred cows' in pursuit of a U-turn. That said, poor businesses in poor industries will be perpetual underperformers no matter who is in charge. To paraphrase Warren Buffett: a good jockey will never succeed on a lame horse.

5. Cheap valuation: The shares must have plenty of upside potential for me to take on the risk that the company may not revive. Current earnings are often useless as a guide in most recovery situations, since profits are either heavily depressed or non-existent. Frequently, I'll apply a suitable 'post-recovery' margin to current sales and from that calculate 'post-recovery' earnings. Dividing the company's market value by this earnings figure then gives me a prospective price to earnings (P/E) ratio (Confused? Here are two examples).

Essentially I'm after a P/E in single digits, which ought to offer the potential for a respectable re-rating should the revival go to plan. I always keep in mind that a P/E expanding from 8 to 12 produces a very nice 50% gain.

What now?

So which shares are on my Champion Shares recovery watch list? Sadly, I can't reveal the turnaround opportunities I'm actively monitoring here. But what I can say is that there is no shortage of possibilities. Since the start of the year, some 59 members of the All-Share index have lost more than 20% of their value! The companies I'm watching will be revealed when Champion Shares launches in the near future - though obviously I can't promise any will produce a 12,100% return! To learn more about Champion Shares, just pop your e-mail address in the box below.