Unless you're "adept" at contrarian investing, says Nigel Milton in Investors Chronicle, investing in recovery shares "should not form the mainstay" of your strategy. Yet there are occasions when markets overreact to a piece of news and this provides an opportunity.
To identify recovery shares, look for turnaround situations, for firms that have suffered a "genuine temporary setback" and "asset plays offering a margin of safety".
An example of a turnaround situation is cash machine operator Cardpoint (CASH, 91p), whose shares fell 43% late last November on news that it planned to close 1,000 of its 5,000 machines following its acquisition of Moneybox. That caused many analysts to downgrade their forecasts for the firm. In fact, it was a recovery stock.
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First off, retailers who offer cash machine facilities draw 15% more customers to their stores (with almost a third of them spending the cash there), so the market is still growing (transactions at Link machines hit a record in December 2005, for example).
Second, buying Moneybox has eliminated its "fiercest" rival, thus allowing it to restore margins and reap synergy benefits. Finally, because it analyses its estate "on a per-machine basis", it knows which cash machines to cull and which to keep.
Yet Cardpoint is now priced on a prospective p/e multiple of less than nine, with a price to earnings growth (PEG) ratio of just 0.11, which is cheap enough to entice at least three high-profile institutions to buy the shares.
Another appealing recovery stock is animal pharmaceutical and feed specialist Lawrence (LAC, 288p), on a 2008 prospective p/e of just 6.9 times (according to house broker Charles Stanley's forecasts). It is suffering after the introduction of its blockbuster drug Aivlosin was delayed.
And retail technology firm Torex (TRX, 88p) is languishing on a PEG of 0.5 after its finance director resigned as a result of a "culture clash".
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