I'm going to share a secret with you today…
I'm going to tell you about a surprising place to find windfall tech profits.
Wall Street refers to them as "special situations."
You might call them "turnaround plays."
High-potential tech turnarounds don't come along that often, and can be tough to find.
But the payoff can be well-worth the search.
So let me start by showing you four tell-tale signals that can help you find these big-profit stocks.
From Rule Breakers to Wealth Makers
Those of you who've been following my columns for some time know that I've spent much of the last few months explaining my Five Rules for Creating Tech-Investing Wealth. Those still hold.
In fact, this search for "tech turnarounds" isn't a contradiction of those rules.
It's kind of an exception.
You see, my five rules are focused on stocks that can double your money in two, three or four years- because we look for companies that are growing sales and profits at a faster-than-average pace.
Tech turnarounds, though, aren't usually on that same growth path. These are tech firms that missed a major market shift, were late debuting a key product, or that stayed with the same manufacturing process long after it was profitable. These are firms that committed strategic miscues or tactical missteps, and whose share prices have been clobbered as a result.
I got involved in this field in a surprising way.
Back in the early 1980s, I had dinner with the undisputed turnaround king of all time – Chrysler Corp.'s makeover maestro Lee Iacocca.
That got me hooked.
I subsequently served as a strategic consultant to an investment banker who financed firms that were restructuring.
All of this gave me the chance to see, firsthand, the impact that a successful turnaround strategy can have on a company, its customers, its employees – and its investors.
I also learned a valuable lesson: To see a turnaround play through to its finish – as a consultant, financier or investor – you need to have the "right" tolerance for calculated risk … and perhaps even be hungry for it.
Here's what I mean …
To succeed as a turnaround investor, you have to be willing to put the money that you've worked so hard to earn into companies that often have steep losses. With this kind of investing, the "fundamentals" that I emphasize with my Five Rules are almost irrelevant.
And yet, there's still a way to get a "margin of safety" built into your investment in these types of stocks.
Take the case of FormFactor Inc. (NasdaqGS: FORM). This specialty supplier of test equipment to semiconductor firms has a market cap of $365 million and trades at about $6.65 a share.
However, the true cost of buying FORM is closer to $4 because the firm has $196 million cash on hand and almost no debt. That gives it a net cash per share of $2.75, lowering your "true cost" by about 40%. (If the firm were to liquidate, that's how much per share you'd be entitled to receive.)
Here's another way to look at it: Because of all the cash, you're buying FormFactor's actual business for about $3.90 a share.
Why the discount? Well, FormFactor's stock sank in late 2009 after the International Trade Commission (ITC) ruled that two competing firms had not infringed FormFactor's patents. It then reported losses amid a weak economy.
But investors are catching on to the company's turnaround story, sending shares up nearly 35% in the past month.
It still has plenty of upside. If it just got back to half its five-year high of $25.67 set on Sept. 7, 2009, it could hit $12.84 – for gains of more than 90%.
Then again, FormFactor meets the four basic criteria or "screens" that I use to judge turnaround candidates.
Let's examine each one:
Turnaround Factor No. 1: A Solid Recovery Starts at the Top
When a company needs to go in a new direction, it has a much better chance at success if there's new blood at the top. New execs bring fresh ideas and new approaches with them and aren't hobbled by old alliances at the firm.
Back in 2010, in order to get FormFactor moving forward, the company hired outsider Thomas St. Dennis as its savvy new CEO.
St. Dennis is a tech-sector veteran, having served two stints at chipmaking equipment leader Applied Materials Inc. (NasdaqGS: AMAT). He also held senior positions at a leading maker of the silicon wafers needed to build chips and at a firm that supplies specialty semiconductors for cars, jets and medical products.
Once he was in place, St. Dennis brought in an entire new senior management team. He now has a group at the top that all have one goal: create the "new" FormFactor.
Turnaround Factor No. 2: All Change Begins With a Catalyst
As investors, we're always looking for the catalyst that will ignite the stock. That's particularly true with turnarounds.
To convince key customers, lenders and investors that a once-troubled firm is on a new path, it has to have something concrete to offer. These can include new products, new markets or better ways of doing business.
In FormFactor's case, the company did all three by pulling off a big merger. Last fall, it bought privately held MicroProbe Inc. for about $100 million in cash and roughly $16 million in stock.
The merger made FormFactor the semiconductor industry's largest supplier of test-probe cards, the specially designed electronic cards used to check the quality of circuits in silicon chips.
St. Dennis is taking a hybrid approach to merging these two firms. He has combined sales, products and technology teams to cut costs and to create a shared vision. But he allowed MicroProbe to keep its name, reflecting its status as an entrenched leader.
Turnaround Factor No. 3: Look For Improving Finances
A troubled tech company just can't put its past behind it unless it can rebuild its balance sheet and its sales and earnings. Otherwise, losses will simply return.
Here, FormFactor is clearly on the right track. Its balance sheet is still a mess, but it is making progress: The firm has restructured operations to slash operating costs while getting products to market faster.
It still needs to cut general and administrative expenses, which rose some 30% in the first quarter compared with last year. But over the last 10 quarters, FormFactor has lowered operating expenses by roughly 35%.
FormFactor also spent $4 million on restructuring charges, a common expense for turnarounds. These items explain why losses of 37 cents a share were up nearly 6% from the first quarter of 2012.
But outlays like this are referred to by Wall Streeters as "one-timers," because they aren't part of the ongoing cost structure of the business. So investment pros often "back out" such costs to get a better idea of the sustainable health of the underlying businesses.
The merger is already helping the combined firm bring in new sales. In fact, sales soared 51% in the first quarter. So-called "top-line" growth is a sign of health – you can manipulate profits with some bookkeeping maneuvers. But sales are much harder to fake.
The upshot: As the company's business improves so will the stock price.
Turnaround Factor No. 4: The Power of New Growth
And FormFactor has one more key factor to recommend it. The recent MicroProbe merger moved it into the growth market for mobile devices – the so-called "Mobile Wave" that we've talked so much about here.
Right now, smartphones and tablets are outselling PCs by a ratio of nearly 5-to-1. Chips for this segment are much simpler than the ones used in PCs. That allows FormFactor to make less complex – and much cheaper – test cards to serve a rapidly growing market.
The firm expects its mobile test products to experience explosive growth. Over the next several years, this segment will soar from the 17% of sales it represented last year to 50%, the company says.
Positioning Yourself for Maximum Profits
Clearly, FormFactor is making all the right moves.
But since turnarounds carry more risk, I suggest that you take steps to add a "margin of safety" to any investment you make.
That's actually quite easy to do.
First, start out by making smaller "entries." For instance, if you generally put no more than 5% in a single position, I would limit a trade like this to 2%. You can also "average in" by starting with a smaller position, and adding to it over regular intervals.
Second, limit your losses.
By using "trailing stops" and "stop losses," your portfolio won't suffer much damage no matter what happens.
But you will be set up to take advantage of a massive move up if FormFactor executes its plan.
The gains from these kinds of stocks can be dramatic – and can come quickly.
Just after the start of the New Year, for instance, I told subscribers of my Radical Technology Profits trading service that I liked Advanced Micro Devices (NYSE: AMD), the troubled chipmaker that has been dominated by Intel Corp. (Nasdaq: INTC).
AMD began executing on its turnaround, with new management, new business possibilities brought on by tablets and new gaming consoles, and a merger that brought new products. The stock gained as much as 66% in four months, and is still up more than 50%.
Best of all – some investment pros are calling for AMD to double – from here….
But our readers were in on it early.
And that's the power of a tech-turnaround play – the massive, hidden profits that are actually easy to find – as long as you know where to look …
Editor's Note: As my recent "Tech Stock Treasure Map" column underscores, I welcome your comments, questions and suggestions. Post a comment below … I look forward to hearing from you.
About the Author
Michael A. Robinson is one of the top financial analysts working today. His book "Overdrawn: The Bailout of American Savings" was a prescient look at the anatomy of the nation's S&L crisis, long before the word "bailout" became part of our daily lexicon. He's a Pulitzer Prize-nominated writer and reporter, lauded by the Columbia Journalism Review for his aggressive style. His 30-year track record as a leading tech analyst has garnered him rave reviews, too. Today he is the editor of the monthly tech investing newsletter Nova-X Report as well as Radical Technology Profits, where he covers truly radical technologies – ones that have the power to sweep across the globe and change the very fabric of our lives – and profit opportunities they give rise to. He also explores "what's next" in the tech investing world at Strategic Tech Investor.