Recovery funds are often seen by cautious investors as having a higher risk investment strategy, due to fears that underperforming companies may never return to full health. 
FE Alpha Manager Alex Savvides (pictured) however, who runs the five FE Crown-rated JOHCM UK Dynamic fund, says he minimises portfolio risk by adhering to a strict framework, which cuts out any stocks that won’t fit in to his investment process.
As such, he has found that he is more comfortable looking at companies that are undergoing a period of underperformance, but still have other attractive qualities that suggest they will find themselves back on the right path in the future.
“I don’t look to be contrarian for the sake of it, but I’ve always found that I am more likely to unearth a situation that may be overlooked by the market, by employing my time focusing on companies that have underperformed,” he said.
“My framework is based around companies that are underperforming for specific reasons. From there we look at whether a company is underperforming and if the results are disappointing to investors in terms of either revenue growth, margins, profit growth or returns on capital. It should follow the pattern that the share price falls and pressure starts to build from the existing shareholders and potential new investors for positive change in the company.”
There are two core factors within Savvides’ framework that narrow down his stock selection – the company has to have underperformed, but its management team also needs to recognise that they have to pursue a different strategy.
In terms of how long the companies have been underperforming for, the manager says it varies depending on how much faith he has in the management team, how certain he is that company fundamentals will change and whether they have strong balance sheets.
“We’re very alive to any opportunities that come our way. A majority of the investments that we make are in companies that have been going through a longer-term malaise in performance which usually coincides with a period of executive tenure, however long that might be, where those executives have taken some decisions that haven’t resulted in the type of financial returns that they would have expected when they made those decisions,” he explained.
“Typically, if there is indeed anything typical, the companies have in some cases been going through five to 10 years of misallocation of capital by their senior executives.”
A prime example of a recovery stock that has been underperforming over the longer term which Savvides holds is Anglo American, which is the fund’s ninth-largest holding.
While it has delivered periods of stellar performance in the past such as during 2007 and 2011, it fared particularly badly during the financial crisis of 2008 and has significantly underperformed its FTSE 100 index over the last three years.
The company’s periods of lacklustre returns have also led to an underperformance over the longer term – over the last decade, it has lost 43.28 per cent while the FTSE has returned 63.74 per cent.
Performance of stock vs index over 10yrs
Source: FE Analytics
“Historically there hasn’t really been the pressure for myopic focus internally on the return in capital on every single investment decision the company makes,” Savvides said.
“That is something that is changing. It has been changing over the last two and-a-half years under a different management team, and it’s changing because the company made a series of very poor capital allocation decisions in 2009, 2010 and 2011, many of which have had to be written down dramatically by the current CEO.”
While Anglo American has been subject to a longer period of underperformance, Savvides also looks at companies whose shares have underperformed over much shorter time frames. He says these cases typically relate to growth companies that are run by inexperienced management teams who have made poor investment decisions.
These investment decisions often become apparent very quickly, according to the manager, which leads to a subsequent collapse in share prices because the market panics about the company’s growth credentials.
While the stocks that Savvides holds have indeed endured periods of underperformance, he emphasises that he will not invest in “distressed” stocks, which is a term he says is often over-used and isn’t always applicable to companies in recovery.
“We only back the companies that either currently pay a dividend or are expected to in the next financial year. Dividends are typically paid out of cash and distressed companies are usually associated with very distressed balance sheets and a lack of cash generation,” he pointed out.
“I would say we look at companies that are underperforming relative to their history and capabilities, and are not necessarily distressed. I think there’s a big difference. People might say to me that Anglo American is a distressed company, for instance, and I would disagree.”
The manager highlights further traits that he will completely avoid as part of his strict framework. One of these is damaged or precarious balance sheets, which will usually suggest that the company needs to raise capital.
As a result, he avoids any company that is likely to need to raise new equity capital before they can start recovering the business.
“I think it’s been quite a sensible thing that we’ve done over the years, to try and differentiate all the ideas available to us and place them into two buckets – those that can survive and prosper with their current balance sheet structure, and those that need to address the balance sheet structure first before they can go onto think about surviving and prospering,” Savvides said.
“The second idea is avoiding companies that don’t pay dividends and these two points are related. If you focus on companies that can and do pay dividends then you are typically isolating the companies that generate cash. It is typically the case that companies that are paying dividends do it out of excess free cash flow, and it’s usually a very good management discipline to do that.”
He says that this makes JOHCM UK Dynamic different from the majority of its peers, which tend to have more of a focus on growth and less on if a company is in a position to pay a dividend.
The third area of the market that the manager will avoid is very small companies that don’t have a long trading history and are very illiquid.
“I don’t back companies that are very new to the world of stock market investing, and I don’t typically back IPOs as they’re not really a fertile hunting ground for our recovery special situations strategy,” he continued.
“I avoid micro-cap companies below £100m. This is me, this is maybe not for everyone as some people like the excitement of smaller companies, but I’ve found historically that some of these can offer much but disappoint a lot, so I take them out of my process all together.”
Out of the fund’s 46 holdings, nine of its top 10 are constituents of the FTSE 100 index. The fund also has positions in the FTSE Small Cap index, the FTSE AIM index and the FTSE 250 index, although Savvides has been reducing his exposure to mid-caps due to stretched valuations.
Since the £333m fund was launched by Savvides in 2008, it has returned 109.4 per cent, outperforming its sector average and benchmark by 52.89 and 61.63 per cent respectively.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
It has also delivered a top-decile Sharpe ratio, which measures risk-adjusted performance, and a top-quartile alpha ratio, which measures performance in addition to the benchmark, over the same time period.
JOHCM UK Dynamic has a clean ongoing charges figure (OCF) of 0.74 per cent, charges a performance fee on outperformance and yields 3.42 per cent.
