Anyone who follows the markets regularly is probably well aware that Wall Street can be notoriously shortsighted, unfairly punishing companies for the slightest of transgressions -- like missing a quarterly earnings per share (EPS) estimate by a penny. In many cases, the underlying cause of the selloff is a temporary concern that is resolved almost as quickly as it appeared.

As value investors, we are always ready to take advantage of this phenomenon and pounce on quality stocks that have been pushed far below their fair value.

Take eBay (Nasdaq: EBAY), for example, which surrendered more than 40% of its value through the first seven months of the year, largely because of overblown concerns that will ultimately inflict little damage on the E-commerce giant. Since we added EBAY to our Half-Priced Stocks "Value/Growth Portfolio" in August, the stock has gained nearly +30%, and it continues to move toward our $46 fair value estimate.

Unfortunately, for every company that rebounds, there is another that continues to sink. Generally, this happens because management just can't find a way to right the ship. In many cases, these struggling firms are disguised as turnaround candidates that appear to be on the verge of making some headway. However, as Warren Buffett once quipped, "turnaround companies seldom turn."

So, what differentiates a value from a "value trap"?

This is often the most important dilemma that value investors must consider. Finding a way to separate the two can mean the difference between earning extraordinary returns and suffering devastating losses.

The challenge lies in separating the companies that will bounce back from those that won't. Clearly, this can't be done on the basis of valuation alone, other factors must be weighed.

Here are several attributes we look for when searching for a compelling turnaround candidate:

Proven Long-Term Performance: It goes without saying that distressed companies are going to have a few operational hitches. If everything was on track, then the shares probably wouldn't have gotten pummeled in the first place.

Obviously, these companies must be afforded a little slack with respect to recent financial results. However, the best turnaround prospects are usually strong companies that have begun to falter, as opposed to weak companies that remain weak.

As such, we look for companies with impressive historical performance figures in years past. These firms have shown an ability to generate healthy growth rates before, and can often be trusted to do so again when they have worked through their problems.

To determine how fast a company can run when its wounds have healed, we compare current revenues, operating income, margins, cash flows and other key metrics against those in each of the past five years. Regardless of how bleak these measures may look at the moment, companies with successful long-term track records can usually be counted on to regain their stride.

Healthy Balance Sheet: There is absolutely nothing wrong with debt, per se. At some point, nearly all companies will use debt in their capital structure. As long as returns on invested capital (ROIC) outpace the weighted average cost of that capital (WACC), then there isn't a cause for alarm.

However, it stands to reason that struggling companies might need excess cash to fix their problems, and those whose balance sheets are already highly leveraged might run into trouble. Furthermore, excessive interest payments will tie up money that could be better spent elsewhere.

All things being equal, companies on stronger financial footing have much more flexibility than those that have dug themselves into a hole. Therefore, you should avoid companies that are burning cash, and instead look for those with adequate interest coverage margins, reasonable debt/equity ratios, and stronger-than-average current ratios (current assets/current liabilities). All of these measures imply that a firm has sufficient liquidity to weather a temporary downturn.

Positive Corporate Culture: Believe it or not, a company's culture can exert a powerful influence over its performance, as well as its share price. In fact, some analysts value a well-defined and enthusiastic culture over all other attributes. 

A firm's culture reflects its core values and incorporates anything from ethics to dress codes to work environment to customer service policy. Obviously, dissatisfied workers are often unproductive, can damage morale, increase turnover and training costs, and can cause other problems. On the other hand, a happy workforce is an intangible asset that will pay off down the line.

With thousands of employees scattered throughout the country (or even the globe), it can be difficult for larger firms to achieve any sense of cohesion without an imbedded culture that provides motivation and incentive for workers to become part of a unified team.

Any sports fan understands the importance of teamwork, positive morale and a winning attitude when it comes to dealing with adversity. Former General Electric (NYSE: GE) CEO Jack Welch used to consider this concept so important that he disseminated written corporate culture statements to all employees at every level of the company. Meanwhile, discount airliner Southwest Airlines (NYSE: LUV) has delivered sensational long-term gains for shareholders, and when pointing to the source of those gains, most analysts give enormous credit to the positive, fun-loving culture created by energetic CEO Herb Kelleher.

Bottom line -- determining whether or not a company has a clearly articulated corporate culture might require some digging, but it is usually well worth the effort.

Battle-Tested Leaders: A firm is only as strong as its leaders, and never is that more apparent than when operating conditions turn sour. When the going gets tough, having a proven management team in place can make the difference between success and failure.

Obviously, this is a qualitative judgment that cannot be easily screened for. However, by taking the time to learn a little more about the tenure, background, and accomplishments of a firm's executives, you will have a better sense of whether or not they have what it takes to navigate the company through a turbulent environment. 

When choosing companies to profile in this newsletter, we prefer to stick with those led by experienced and adaptable managers who have demonstrated an ability to thrive under a variety of conditions.

Transparent Earnings Releases: When it comes to quarterly earnings releases, some companies post only the bare minimum, with no cash flow statements, no pertinent statistics, and scant additional commentary.

Others will provide more information, but will downplay any specific areas of weakness (either burying them far down in the press release or omitting them altogether), while trumpeting the smallest improvements.

Then there are those that go out of their way to provide investors with a treasure trove of analytical details and insightful commentary. Typically, these companies are also very straightforward and responsive with shareholders, candidly admit to any missteps, and do a commendable job of managing Wall Street's expectations.

Case in point -- Berkshire Hathaway (NYSE: BRK-B) recently went so far as to point out that its sensational third-quarter earnings were more of an anomaly than the result of keen leadership.

Without question, we prefer to invest in straightforward firms that offer full disclosure. With struggling turnaround companies, it is particularly important to focus on those that supply the necessary information to keep shareholders informed about current trends and future expectations

Value traps can be difficult to spot, because they often display many of the same characteristics as traditional value stocks. However, those firms that meet the criteria above are, by definition, proven former winners in sound financial condition. They also have positive attitudes and communicative leaders with the experience to guide the corporate team through a temporary business slump. 

Thanks for reading!

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