5 Top Turnaround Stocks

Everyone loves a great comeback story. In the stock market, few things are more enjoyable than owning a stock on the cusp of its own massive turnaround. After all, many fortunes are made by investors who buy great businesses:

1. During times of maximum pessimism,

2. While they're being ignored and forgotten, or

3. When they're being beaten down to bargain-basement levels.

Meet the turnaround tycoons
Those investors see what others don't. More importantly, they're willing to bet big on the stocks they believe will enjoy a reversal of fortune. Notable investors who've followed this strategy include Buffett, Templeton, Klarman, and many more.

We probably can't help you with your contrarian spirit, but we can offer you five possible turnaround ideas from our Motley Fool CAPS community. Despite being down 15% or more over the past year, these stocks have received a four- or five-star rating (out of five) from our pool of individual and professional investors. Our candidates today:

These stocks have been slammed for very specific reasons, so don't view them as formal picks. They're simply suggestions you might want to investigate further. You always need to do due diligence -- especially when you're playing with tricky turnarounds.

Digital dilemma
Despite being the leading provider of conditional access systems to China's digital television market, disappointing demand has weighed on China Digital's shares recently. The company has seen year-over-year revenue declines in each of the last two quarters, prompting Mr. Market to reconsider just how tantalizing the company's tailwinds -- the most significant of which is the Chinese government's desire to switch off analog signals by 2015 -- truly are. Of course, with 50% of the domestic smart card market and a forward P/E of 12, China Digital seems at least worth a look.

Early this year, CAPS member iddqkfyou summed up the bull case:

This is not some TV manufacturer or wireless television station, they make what allows T.V. systems of the future function, and with their recent investment in OpenV, a Chinese Hulu with tens of millions of viewers, they are positioned to branch into content delivery and advertising. ... This company has a good business and should grow, yet you can pick it up for nothing.

Getting drug down
With about $1.5 billion in long-term debt and just $865 million in cash on Elan's balance sheet, Mr. Market seems right to be nervous about the biotech's financial footing. Throw in the company's heavy reliance on multiple sclerosis drug Tysabri, a treatment that continues to face infection concerns, and it's no wonder that the stock is down by 38% over the last three months alone. Still, with powerful partners such as Johnson & Johnson (NYSE: JNJ) and Pfizer (NYSE: PFE) helping to ease cash burn, and the possible divesture of its drug delivery business, Elan looks like an intriguing "special situation."

Two days ago, CAPS All-Star bg11235 touched on the stock's attractive risk/reward trade-off:

Main revenue driver Tysabri (MS) faces headwinds due to risk of infection. Nevertheless, it's still a high margin drug and a deal with J&J passes on R&D expenses for Elan's major pipeline drug. Both factors will lead to improved net margins and royalties from drug delivery products will add support to the bottom line. Whether that's enough to sustain the company until the pipeline develops is a crap shoot. At this price, though, the risk is discounted too heavily.

A call to arms
Declining overall firearm demand, coupled with market share strides made by rival Sturm, Ruger (NYSE: RGR), have Smith & Wesson's stock in a fairly flat range in 2010. Firearm sales, which still account for more than 80% of the Smith & Wesson's business, decreased 11% in the company's third fiscal quarter. A good indicator of firearm sales, FBI background checks, remain well off the all-time highs set last year, but with the stock trading at a paltry P/E-to-growth ratio (PEG) of 0.7, Smith & Wesson might be too cheap not to take a shot on.

Two months ago, CAPS member AllSpArK took aim at the bear case:

[Smith & Wesson] is not a company in bad shape. ... [P]rofitable, solid management. What is to hate enough to push it to 52 week lows? I read Foolish articles about the main business line (gun sales) being in problems. But is this market so naive to have boosted the stock on a simple premise of short term earnings? No sir. My target for [Smith & Wesson] is $5 within months.

Now its your turn(around)
Turnarounds offer an exceptional way to wallop the market's overall returns. The catch, of course, is that you'll need more time and effort to figure them out.

However, the more than 165,000 fellow Fools in our community can help you get a head start on spotting some of the more probable plays. Get started now, absolutely free. More tasty, terrific, and (we hope) triumphant turnaround treats await.