Recovery fund managers have traditionally been regarded by their more conventional colleagues as a b...
Recovery fund managers have traditionally been regarded by their more conventional colleagues as a breed apart. Not for them the subtle art of closet index tracking or following the crowd by investing in momentum-driven sectors.
Indeed, they typically feel more comfortable going against the grain, seeking out undervalued companies that, for various reasons, have encountered problems, suffered neglect or merely become unfashionable for no rational reason.
Recovery fund managers require specialist skills and endless patience to find apparently unattractive companies whose superficial ugliness disguises great potential that can be unlocked by management action or takeover activity.
But lowly valued companies are often in this position for very good reasons. Like wrecks on the seabed, they are dangers that must be must be avoided at all costs. Recovery managers need sound judgement to separate the potential winners from the looming disasters.
Companies are most likely to come under pressure in times of recession as they discover previous ambitions and optimistic revenue assumptions have turned to ashes, leaving them to cope with stretched balance sheets or the consequences of a flawed acquisition strategy.
By that definition, after three consecutive years of negative returns, the whole of the stock market could currently be described as being in line for recovery treatment. The extraordinary technology-driven climax to the 1990s boom has left companies and investors in an enfeebled and shell-shocked state, with limited ability to assess future trends and a reluctance to embrace any form of risk.
The extreme divergences between returns produced by different sectors since the peak in 2000 has created yet more complexity. Since then, only six sectors have made any gains, with traditional defensive sectors, such as food, tobacco and utilities, outperforming vulnerable and once highly-valued areas by a huge margin.
Furthermore, there have been significant variations between the performance of individual stocks in the same sector, especially among mid and small-caps, where limited liquidity tends to exaggerate strengths and weaknesses.
Fund managers taking a recovery approach have seldom been presented with so many anomalies and opportunities to sort out the wheat from the chaff.
Although recovery investing is a well-established style, it requires both strong convictions and a willingness by the fund manager to carry out his/her own research. Relying on brokers, who are less comfortable with search for recovery candidates, is not really an option.Indeed, difficult stocks rated a sell by most analysts are often the starting point. But in any case, the real added value comes from discovering a genuine anomaly oneself rather than waiting until a company's improving situation is plain for all to see.
The cycle of recovery dictates managers buy neglected stocks, run them until their inherent value is realised and then look to sell them and use the proceeds to repeat the process with other companies. The timing of selling and buying decisions is important and can lead to a degree of unevenness in performance. Flexibility is the key.
In theory, the richest prospects should lie in sectors that have been absolutely hammered over past three years. However, this assumption should be treated with care. Many technology stocks, for example, are still not cheap, despite losing more than 80% of their value, and face a further period of poor trading news.
The M&G Recovery fund currently has substantially underweight positions in the technology, media and telecoms sectors and among other severely underperforming areas. Only in the cases of aerospace and defence and support services is exposure well above the respective positions in the index.
Clearly this position may change but it would require either considerable further weakness in their share prices or evidence the fundamentals are starting to improve for this to happen. By contrast, the fund holds overweight positions in food producers, mining and oil, all of which have performed relatively well but still offer attractive valuations.
Our approach to recovery investing is pragmatic, driven by decisions on the merits of individual stocks rather than any top-down macroeconomic view. In making our selection, we place enormous emphasis on understanding the businesses in which we invest.
We rarely invest in any company without first meeting the management and carrying out a far-ranging discussion on the issues facing the company and the strategy required to resolve them. Dialogue with the company is usually on-going. Without telling management how to run the business, we will not hesitate to make constructive suggestions or at least ensure our opinion is clear.
The multi-faceted aspect of our strategy can be seen in the fund's six largest overweight positions relative to the index: Tullow Oil, Ashanti Gold, Pennon Group, Somerfield, Associated British Foods and Arriva. This is a highly diversified list but with a heavy non-FTSE 100 bias. It includes two names that are little known to either fund managers or analysts: Ashanti, the Ghanian gold mine, and Tullow, an oil exploration company with interests in Asia and the North Sea.
Key themes in our strategy are the breadth of the fund's investment universe and our willingness to seek out little known but interesting companies, whose share valuations do not reflect the true value of their business. Restructuring and management change are important ways to regenerate ailing companies.
Somerfield, a food retailer with a turnover of £5bn and a poor management history, is a promising early-stage recovery candidate. Our interest was raised by the arrival of John von Spreckelsen who, when chairman of Budgens, had revived the fortunes of the company. The list includes Arriva (buses and trains) and Pennon (water), where restructuring has largely been completed but is yet to be reflected in valuations.
Recovery investing might be criticised for being too far from the mainstream and too unconventional. But conventional investment approaches have faltered in the difficult conditions of the past three years, while the recovery style, as measured by the performance of the fund, has beaten the FTSE All-Share Index.
After three years of negative returns,the whole of the market could be described as in line for recovery
The extreme divergence between returns produced by sectors since the peak of 2000 has created yet more complexity
In theory, the richest prospects should be in sectors that have been hammered in recent months
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