For many investors, the idea of buying a stock that is in the midst of a challenging period is somewhat undesirable. After all, the old saying 'it is difficult to catch a falling knife' can be rather accurate, with it being difficult to know exactly when is the best time to take the plunge and add a declining stock to your portfolio.
However, for me the key is to select companies that offer wide margins of safety. That way, even if things do get worse then low valuations should act as a support against further share price falls. And, if things turn out to be better than expected, then the upside potential of the share in question could be significant.
A challenging period
Of course, buying a stock that is struggling is never easy and requires a large dollop of courage. For example, buying a slice of Rio Tinto Limited (ASX: RIO) at the present time requires a lack of emotion and a large reserve of logic. That's because the iron ore specialist has posted a share price decline of 16% in the last year, in part due to a falling iron ore price that has caused Rio Tinto's bottom line to plunge by almost 20% in its most recent financial year. And, looking ahead, further falls in net profit are anticipated over the next two years, with a decline of 21.4% per annum being pencilled in.
Likewise, Woolworths Limited (ASX: WOW) is experiencing a challenging trading environment, with Aussie consumers becoming increasingly price-savvy and focused on value for money as disposable incomes begin to come under pressure. Furthermore, the rise of no-frills operators such as Aldi and Costco has also eaten away at Woolworths' sales figures and caused a price war to commence, with Woolworths' margins being hit and its net profit being forecast to decline by 3.5% per annum during the next two years. As such, Woolworths' share price is down 20% in the last year.
Looking ahead
While things may look dire for Rio Tinto and Woolworths, now could be a great time to invest in them as a result of their wide margins of safety. For example, Rio Tinto trades on a forward price to earnings (P/E) ratio of just 14.1 (using forecast earnings for financial year 2016), which is much lower than the ASX's P/E ratio of 16 and shows that even with its disappointing outlook it remains good value. And, with Woolworths having a price to sales (P/S) ratio of 0.6 versus 1.5 for the ASX, its shares also offer excellent relative value.
Furthermore, both Rio Tinto and Woolworths have excellent yields, with them currently standing at 5.1% and 4.8% respectively. Both are ahead of the ASX's yield of 4.5% and, with them being covered 1.2 times and 1.4 times respectively by net profit, they appear to be sustainable even considering the challenging near-term outlook for both stocks.
As such, and while the short run may not see a major improvement in their financial performance, the wide margin of safety on offer via Rio Tinto and Woolworths means that, for long-term investors, they appear to be superb turnaround stocks to purchase at the present time.
