Looking for mispriced shares isn’t easy but there is a group of fund managers with the necessary tools
Thursday 14 Nov 2019 Author: Tom Sieber

What do recovery funds do, what is their appeal and what do they invest in? In simple terms a recovery stock is a share which has fallen in price but is seen as having the potential of climbing back or even exceeding its previous level.

This recovery would usually be achieved through a change of strategy or perhaps efforts to repair a broken balance sheet and would often be accompanied or preceded by a change in senior management.

In many ways investing in recovery situations aligns with the approach of value or contrarian fund managers, who look to buy unloved companies where there are catalysts for a rebound, as well as special situations funds.

WHAT IS THE APPEAL?

The returns when you call a recovery right can be significant. Looking at this on an individual stock level, electrical goods distributor Electrocomponents (ECM) has been revitalised since CEO Lindsley Ruth was appointed in April 2015.

Although the ride has been a bit bumpier in the past 12 months, which is unsurprising given the company’s direct exposure to an increasingly volatile economic backdrop, Ruth has put the business back on a growth path, tackling management inefficiency and slashing costs. This has been rewarded by the market with a near-200% increase in the share price since he took over.

Manager Alex Wright, who steers Fidelity Special Situations (B88V3X4) and investment trust Fidelity Special Values (FSV), looks at his investments in three distinct stages.

Stage one: An initial position will be taken; I will increase the holding as and when conviction increases. Once the operational change takes effect, and an improvement in growth is evident, the company moves to stage two.

Stage two: Start of perception change by the wider market, leading to a re-rating of stocks. At this point, I will allow the position to increase in size.

Stage three: The company’s recovery process is well underway and the share price is close to my upside target; other investors are buying into the growth story. There is now less downside protection and less upside potential. At this point, I will reduce the position and recycle the proceeds into stage one companies.

As an example of how this works in practice, Wright sold out of Lloyds (LLOY) on the basis the company had already cut costs and achieved efficiencies, while Royal Bank of Scotland (RBS) is still held in the portfolio because it is at an earlier stage in its recovery.

A HIGH RISK APPROACH

Investing in recovery stories is a high risk approach as the price of failure can be total. Investment trust Lowland (LWI), managed by James Henderson, was one of small number of funds which held a position in Carillion at the point of its liquidation in early 2018, for example.

Arguably risks are higher during an economic and market downturn when companies with flawed business models or strained finances are likely to be more exposed. Although on the flip side as Fidelity’s Alex Wright points out: ‘Weak market sentiment can sometimes throw up the best investment opportunities.’

By investing through a fund you benefit from the expertise of a fund manager who specialises in distinguishing between a genuine recovery opportunity and a firm which can’t be fixed.

And even if they get this wrong, a diversified portfolio means the pain incurred through a mistake is less severe for an individual investor, particularly if they are prepared to be patient.

The manager of M&G Recovery’s Tom Dobell says: ‘There are times when companies, sometimes once-great ones, are doomed to fail. Business models can be rendered irrelevant by innovation and debt mountains can become insurmountable.’

As Dobell points out the determining factor is often the people at the top. ‘Company management must also demonstrate that they have a clear strategy to generate profits and growth over the coming years – after all, it is the prospect of these that justifies the risks of investing. You have to be selective.’

PICKING A RECOVERY FUND

Just as a recovery fund manager needs to be selective, it also makes sense to be selective in terms of your exposure to the funds themselves for several reasons.

First, as discussed, by their nature the performance of recovery funds is likely to be more volatile given the risks involved in buying companies whose fortunes need resuscitating.

Second, many recovery funds are invested in similar areas of the market, so owning more than one fund could leave you over-exposed to certain sectors.

A lot of UK-focused funds in this space are invested in banks and oil companies. For example, oil major BP (BP.) and bank HSBC (HSBA) are in the top two holdings for M&G Recovery, Schroder Recovery (B3VVG60) and River and Mercantile UK Recovery (BG21HH8).

There are funds with broader horizons which invest in global recovery plays, including River and Mercantile Global Recovery (B9428D3).

We suggest you buy Schroder Global Recovery (BYRJXL9) which invests in UK and overseas stocks such as emerging markets bank Standard Chartered (STAN) and US IT company Hewlett-Packard.

Fund managers Nick Kirrage and Kevin Murphy both have around two decades of investment experience. The portfolio typically contains between 30 and 70 stocks.

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