Top 3 Turnaround Stocks Ready to Explode

Every investor dreams about buying a beaten-down stock and riding it to riches.

These are the kind of investments that can fuel incredible returns and give your portfolio a serious boost. But even though it may sound like something best left to Wall Street‘s finest, I am going to share a secret strategy to help you find the best turnaround stocks with huge upside.#-ad_banner-#

Regardless of whether the turnaround is fueled by a change in management, an acquisition or new products and services, this strategy captures the fundamental drivers fueling the transition. It’s also a technique to help analyze a stock’s value in addition to nominal price movement.

The strategy I am talking about lies in earnings estimates.

Many stocks on Wall Street are covered by more than 20 analysts. These analysts follow the companies closely on a daily basis, keeping tabs on sales and various performance metrics. It’s not easy to surprise the analyst community and trigger a sharp upward revision in earnings estimates. When that happens, it is a big signal to the market that something has changed very quickly, and that the company is effectively executing its new goals. A price jump without the support of surging estimates is a signal that the turnaround is more style than substance.

Take a look at the table below for a visualization of an upward revision in earnings estimates.

But movement in estimates isn’t just a great way to find the best turnaround stocks; it’s also an opportunity to analyze value. A 10% increase in shares on a 5% increase in estimates looks much more attractive than a 50% increase in shares on a 10% increase in estimates. Using analyst estimates is a highly effective method of framing share price movement within the context of actual earnings. In the case above, Repligen saw an 80% increase in the current-year estimate, but less than a 50% increase in stock, which makes the valuation more attractive.

Turnaround stocks can also be a great tools for diversification, with a lower correlation to the market averages as these turnaround stocks drive movement more than general market sentiment.

Putting the strategy to use, here are my three favorite turnaround stocks in position for big gains:

1. Pulte Group (NYSE: PHM)
With housing and housing stocks beaten into the ground during the financial crisis of 2008, this is a good sector to look for turnaround stocks. This definitely shows up in estimates for the Pulte Group, with the current-year earnings estimate for this home builder almost doubling in the past 60 days after climbing from 28 cents per share to 51 cents per share.

Those are unique fluctuations in estimates that speak of big changes and growth. Although Pulte Group has seen big gains since then, jumping from $11 to $16 a share, the stock still only trades at 17 times projected earnings per share of 89 cents in 2013. Returning to the industry average of 19 times would be good for a quick 12% pop.

2. Smith & Wesson Holding Corp. (Nasdaq: SWHC)
Gun stocks have been red hot in 2012, burning up the charts and delivering huge gains to investors. But this isn’t an investment fad based on hope — the industry is seeing a huge resurrection under waves of sales and demand.

Nowhere is that more evident than in Smith & Wesson, with its current-year earnings per share estimate up 71% in the past 90 days and 36% in the past 60 days. Those are powerful moves that speak of surging demand and rapid growth. But with shares up only 10% since those upward revisions hit the wire, Smith &Wesson is trading deep in value territory, with a forward price-to-earnings (P/E) ratio of 12, a sharp discount to its 10-year average of 19 and the industry average of 14. If the stock returned to its 10-year average forward P/E, then Smith & Wesson would climb above $17, a 58% increase from current levels.

3. Impax Laboratories Inc. (Nasdaq: IPXL)
The health care and biotech industries are also good places to look for turnaround stocks, littered with companies making big product and technological breakthroughs that will drive future business. That is exactly what is happening with this generic drug maker, with the current-year estimate jumping 15% in the past 60 days after climbing from $1.80 to $2.07 a share.

But with shares only showing marginal gains since the upward revision, Impax is trading at a discount to the industry and its 10-year average. If Impax were to return to its average forward price-to-earnings (P/E) ratio in the past 10 years, then shares would move back above $30, a sharp 25% gain from current levels.

Risks to Consider: Expectations tend to run high for turnaround stocks, making them prone to sharp downward moves on any negative or disappointing news. It’s also very important to monitor fluctuations in estimates to be able to determine whether shares are being driven by actual earnings.

Action to Take –>  These three stocks have all seen dramatic upward revisions in earnings projections in the past three months. That is a big signal from the analyst community that the group is beating expectations. But with the valuation still looking attractive, all three stocks are in position for big gains.