Recovery investments can be out of favour for many reasons, including weak short-term profitability, economic concerns or an under-strength balance sheet.
Exploiting human natureHuman nature doesn’t change. When the economy, or indeed an individual business, faces tough times, it is natural to focus on the negatives. Most investors will focus heavily on the bad news, but even in the most challenging economic times, insolvency is rare.
Historically, the market underestimates the ability of businesses to improve their situations over time. Such instances are most prominent during times of greatest volatility, when share prices move significantly more than the real value of the companies they represent.
At times of fear, investors look to sell shares irrespective of cheap valuations, thereby giving value investors the opportunity to buy bargains.
Looking for signs of life
Companies, like people, frequently get sick. Most have the potential for rehabilitation, but they often need a little surgery. When sifting through potential recovery stocks, you must ask yourself: "Why can’t this business make reasonable profits again?"
There are several reasons not to invest in a company: a poor management team, a weak business model or a balance sheet that does not provide an adequate margin of safety.
A detailed analysis of the risks and rewards associated with every potential holding must be carried out and we spend a lot of time studying company accounts to give us a clear picture of how a company performs across the business cycle.
To what extent is a profit recovery within the company’s own control? Or is it dependent on external conditions? And what are the major risks associated with it?
Finally, look closely at balance sheets to ensure companies have sufficient capital strength to see them through short- and medium-term challenges and, if not, whether any credible routes for reducing indebtedness – a rights issue for example – will still leave investors with strong potential returns.
All in all, if we can see a favourable balance of risk and reward over a three- to five-year time horizon, we will buy that company on the basis that our patience is likely to pay off significantly in the long-run. Unlike in A&E, we have the advantage of being able to ignore the terminally sick and focus on companies with the best prognosis.
Risky recovery?
One question we are often asked is: aren’t recovery stocks risky? The short answer is: not necessarily, no. We often see other investors classifying risk as volatility. However, volatility in itself is not risk – real investment risk is the chance of permanently losing some or all of the money that you have invested.
In-depth analysis of balance sheets and financing arrangements ensures that the capital risks of investment are well understood and negated where possible. Where this is not possible, we can make sure that we are compensated by very significantly increased potential returns.
In fact, since the intrinsic value of companies seldom moves significantly over short time periods, volatility suggests emotional behaviour and is consequently an opportunity for value investors.
It is also important to stress that "benchmark risk" has no place in recovery investing. The benchmark is an excellent way to measure returns over long time periods, but it is a terrible way of measuring risk. This is because a benchmark-focused appraisal of risk lures investors into buying stocks with large market capitalisations, rather than towards stocks with the largest potential returns. In other words, it draws you in to buying stocks that you do not think are good investments.
The future is inherently unknowable; no-one has a crystal ball. We cannot know what will happen tomorrow. This is why, in our view, it is vital to explicitly avoid taking economic views that may influence portfolio decisions.
Some would question if it is prudent to ignore factors like interest rates, inflation, unemployment, or thematic trends like emerging market growth or the negative outlook for consumer spending.
While we are mindful of their impact, our style of recovery investing’s record of outperformance shows that an unemotional, valuation-based recovery approach delivers – regardless of these prevailing economic or thematic factors – over the long run.
Even when themes are correct, there is potential to deliver strong returns by taking a contrarian view. For example, some UK retailers (such as Next or Dixons) have bucked the trend and delivered very strong share price growth in recent years, despite the poor economic environment.
Investors are often reluctant to buy shares in a company until all of its problems appear to have been solved – by which point, of course, much of the money-making opportunity will have been lost.
That can, quite literally, be a high price to pay for certainty and peace of mind and is a feature of the stock market that value investors exploit to their advantage.
Learning from history
What you pay, not the growth you get, is the biggest driver of future returns. At the height of the dotcom bubble in 2000, money was pouring into the tech sector, pushing up prices as investors expected stellar increases in profits and growth to continue. At the other end of the spectrum were tobacco companies. Unloved by the market, hampered by litigation battles, and in structural decline in their traditional markets, company valuations floundered.
Ten years later, if you had invested in British American Tobacco you would have more than tripled your money. If you had invested in Amazon, you would have made no money.
You might think this is because the profit growth assumptions made by investors in 2000 were wrong. They were in fact proved to be correct: the profits at Amazon grew faster than British American Tobacco.
The key difference was the starting valuation of each stock. When it comes to equity returns, what you get is important, but what you pay is a paramount. Of course, no-one can forecast exactly when the market will recognise the intrinsic value of a recovery stock, but by placing emphasis on shareholder friendly management teams and low valuations, investors can recognise companies with considerable potential for sustainable long-term share price recoveries.
Kevin Murphy is the co-manager of the Schroder Recovery fund. The views expressed here are his own.