Why these turnaround stocks could beat the Footsie in 2018

Roland Head highlights two contrarian picks from his watch list.

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When’s the right time to invest in turnaround stocks? It’s rarely possible to call the bottom, but one approach I’ve found useful is to look for situations where the stock falls following good news. This can be a sign that a buying opportunity is developing.

Down on good news?

I’m beginning to feel that education firm Pearson (LSE: PSON) could be an example of a turnaround that’s on the cusp of recovery.

The group’s shares fell by around 5% today after the company issued a full-year trading update for 2017. Management now expects to announce an adjusted operating profit for the year of £570m-£575m. Adjusted earnings per share should be around 54p, ahead of consensus forecasts of 50.1p per share.

The group’s net debt fell from £1.1bn to “around £0.5bn” over the last year, a level that I believe should be comfortable for this business.

But what about the future?

Pearson has generated a lot of cash from asset sales over the last year, including selling a 22% stake in book giant Penguin Random House. Although this has helped to repay debt, it will also reduce profits, at least initially.

The main focus of the slimmed down Pearson business is the US education market. The group is hoping to combat falling demand for printed textbooks by moving more aggressively into the e-book and rental markets.

The success of this plan isn’t yet certain. Underlying revenue fell by 2% last year and a further modest decline is forecast for this year. However, profit guidance for 2018 suggests that adjusted operating profit will be between £520m and £560m.

After making some adjustments, I estimate that the comparable figure for 2017 is £500m-£505m. So profits seem likely to rise this year.

These profit figures imply an operating margin of around 9%. With the stock on a forecast P/E of 14, I believe the shares could climb if Pearson can deliver on today’s guidance.

A difficult choice

Another tempting turnaround selection is broadcaster ITV (LSE: ITV), which has also won the support of fund manager Neil Woodford. The group’s shares have fallen by more than 35% from their 2015 peak, as the market priced-in the risk of falling ad sales and slower growth.

So far, nothing drastic has gone wrong with this business. As a result, ITV shares now trade on a forecast P/E of just 10.8 and offer a prospective yield of 4.6%.

What could go wrong?

Television advertising sales have been falling. Advertising revenue dropped by 3% in 2016, and the group expects this figure to have fallen by a further 5% in 2017.

The reality is that much of ITV’s growth in recent years has been driven by its decision to acquire many of the programme makers which supply the firm’s channels. I’m concerned that some of these acquisitions could prove to be one-hit wonders.

Despite this risk, ITV’s 18% operating margin remains tempting to me, given the stock’s modest valuation. And the group’s balance sheet also looks healthy, in my view.

It’s also worth noting that the group’s new chief executive, ex-easyJet boss Carolyn McCall, started work on 8 January. If Ms McCall can convince the market that this business will return to growth, then I think the shares could perform strongly this year.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended ITV. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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