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Why talk of a turnaround at this firm leaves me cold, and what I’d buy instead

I reckon hunting through the dustbin of troubled businesses in search of a decent turnaround candidate is fraught with difficulty. Often, companies talk the turnaround talk while doing nothing of the sort.

On top of that, it’s difficult to time the purchase of a bombed-out share. You can use all the value indicators in the world and still find yourself buying when there’s a further 90% or so for the stock to fall! In cases like that, even if you get the turnaround you wanted, you can still end up losing money on the share because a 90% fall requires a 900% gain to break even, and that’s a tall order.

A low valuation

One superficially tempting-looking turnaround proposition exists in distributor Connect Group (LSE: CNCT), which sports a forward-looking price-to-earnings ratio for the trading year to August 2020 of just under 4.5. Cheap, cheap, cheap, but the problem for me is that the business isn’t a very good one in the first place, and I’d rather seek turnaround candidates from among enterprises operating in more attractive sectors.

Connect operates in newspaper and magazine wholesaling, and mixed freight distribution with brands Smiths News and Tuffnells. The sector is characterised by low margins, high competition and weak product or service differentiation. I’d describe the business as commodity-style, so it seems unlikely to me that the company will ever sport decent quality indicators. I reckon any turnaround in fortunes will be limited unless Connect changes direction.

Today’s half-year report for trading to the end of February makes grim reading. Compared to the equivalent period the year before, the adjusted figures show revenue down 4.4%, operating profit almost 28% lower, earnings per share sinking 36% and free cash flow collapsing by 42%. One bright spot in the figures is that net debt has fallen by 7.3% to £77.5m, but that remains a mighty pile of borrowings, which is almost as high as the figure for market capitalisation.

An optimistic chief

But chief executive Jos Opdeweegh seems optimistic in the report, saying that there was a “good performance” from Smiths News, an ongoing turnaround opportunity in the Tuffnells business and “further benefits from central efficiencies and focused capital management.” One thing I do like is that Opdeweegh only took up his position in September 2018, so will be looking at operations with a fresh eye, new determination and plenty of vigour. However, I reckon the poor economics of the business will prove to be a challenge and I’m not prepared to risk my capital by buying any Connect shares.

Investing in smaller companies listed on the stock market can be a decent strategy. But I’d target firms that are growing and trading well rather than companies that have become small-caps because of declining trading and falling share prices. As an alternative to picking individual small-caps, I’d also look at tracker funds that follow small-cap shares, or perhaps one that follows the FTSE All-Share Index.

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Kevin Godbold has no position in any share mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.