Recovery stocks – boost your wealth and your ego

Buying out-of-favour, beaten-down stocks may require impetuousness bordering on recklessness, says Max King but it can be mighty satisfying when it pays off.

There are few investments more satisfying than buying out-of-favour shares and then seeing them multiply in value. The satisfaction comes not just from the profit made but from being right when nearly everyone else is wrong. Naturally, investors remember their winners more easily than their losers but, until the new millennium at least, the profits from the winners swamped the losses from the disasters.

The risks of buying in the hope of a rebound

Before 2000, fortunes were made by buying the shares of companies that had temporarily hit financial trouble, such as oil giant BP, engineer British Aerospace and fashion chain Next, and then seeing them bounce back dramatically. That still happens today: IAG (which owns British Airways) has risen five-fold in the past five years, and the miners and housebuilders have recovered strongly from their post-recession crises but it is less frequent.

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What's changed? The number of companies that actually end up going broke, rather than recovering such as support-services group Carillion is no higher now than in the past. However, many more such companies turn into lame ducks rather than enjoying a spectacular rebound. Sometimes, as with once-dominant mobile-phone group Nokia, the company fails to keep up with new technology. Sometimes, the underlying problems turn out to be far worse than expected for example, investors were burned by buying back into the banking sector too early in 2008. The cost of BP's Macondo oil spill in the Gulf of Mexico in 2010 was multiplied by dishonest claims, encouraged by the authorities. Much the same has happened in Britain with payment protection insurance (PPI) claims from UK banks.

Recovery investors can't wait to be certain

"There has been more structural risk risk that businesses don't turn around so the odds became more adverse," says Alastair Mundy, manager of Temple Bar Investment Trust (LSE: TMPL) and one of the few remaining practitioners of recovery investing. "Everyone has been buying quality' companies with great cashflow, strong management and high barriers to entry, so being a recovery investor has become a poor career choice for youngsters. It has become difficult for managers to step out of line."

Internal rules and regulation require more due diligence on research and far more to be written down, but that's not always helpful when making the case for buying a stock that appears to have the odds entirely stacked against it, notes Mundy. "If you think about investing in a recovery share too hard, you won't make a decision."

The shares of companies that announce bad news routinely collapse on the assumption that this is just the beginning of a relentless slide which will be very difficult, if not impossible, to reverse. Existing investors rush for the exit at any price, while new ones stay clear. As Mundy says, before they invest, investors want to see "a catalyst, good news and upgrades to earnings forecasts. Investors demand more certainty on these stocks than on any others, and pursue an impossible level of due diligence and visibility." The problem is that by the time these conditions of sufficient certainty are fulfilled, the share price will already have recovered dramatically.

Throwing in the kitchen sink

One reason that recovery investors need to act quickly to catch the best opportunities is that company management teams have an incentive to "kitchen sink" any bad news they announce, the sooner to embark on the recovery process. As a result of this and of investors' overreaction, many see their share prices bounce back when the outlook turns out to be better than feared. There are several recent examples of this phenomenon in action.

The shares of funeral group Dignity fell by 70% on the back of a profit warning near the start of this year, but have since bounced by 30% on more reassuring news. In March, shares in technology group Micro Focus crashed by 67% (including a 40% drop in a single day), when it admitted to problems arising from its acquisition of Hewlett Packard's software unit. Yet the share price has since rebounded by 40% and realistically, the fact that the integration of a business with a very problematic history would not be straightforward should not have surprised anyone. Last year, the shares of doorstep lender Provident Financial fell by 80% after the failure of an overhaul of its 130-year-old business model and a regulatory investigation. However, since February this year, when the company shored up its finances with an £800m rights issue and settled the regulatory dispute, the shares have bounced by 90%.

Some promising recovery plays

Mundy has recently been increasing the exposure of his Temple Bar fund to recovery stocks. He favours support-services group Capita (LSE: CPI), which "investors thought was another Carillion, with too much leverage, low margins and loss-making contracts". Yet Capita has raised £700m in a rights issue, "can recover to double digit margins" and "its contracts have turned out to be not so onerous". The share price has already rebounded 35% from its low point.

Mundy also likes estate agency Countrywide (LSE: CWD). The group has "lost a lot of market share, which investors assumed was to online agents, but was actually to local competitors. Previous management took the entrepreneurial spirit out of branches and cut back on staff, but self-help can drive profits back up." Again, the shares have already started to rally the appointment of Peter Long, the ex-chief executive of tour operator First Choice (now Tui) and chairman of Royal Mail to the position of executive chairman, has helped the shares bounce 30%.

As for the banking sector perhaps one of the most toxic of all while other managers go for the safer options of Lloyds and HSBC, Mundy is focusing on RBS (LSE: RBS).There is no shortage of bad news when it comes to RBS there is a large overhang of government stock, the deadline for PPI claims is still a year away, and it has just been fined $3.6bn by US regulators over its role in the sub-prime crisis but Mundy prefers to be an early investor. "Investors demand a clean story but, by then, the price will have moved. You pay a much higher price to know a little more, so it's not worth waiting."

Retailers are another area of potential, he reckons. Food retailers have already recovered, but a few years ago the consensus view was they couldn't compete with fast-growing German discounters Aldi and Lidl. Now they are focused on cash generation and profits, their fortunes have improved and Asda's merger with Sainsbury should help further. Marks & Spencer's (LSE: MKS) share price has more than halved in the past three years, but the appointment of Archie Norman, who presided over broadcaster ITV's renaissance, may signal a turning point. "It was slow to react to fashion changes, fell behind in online sales, moved away from its core customers and had too many layers of management, but the demise of high-street competitors could be helpful," argues Mundy.

Despite past successes and the promise of future ones, Temple Bar's performance over three and five years has lagged that of the FTSE All-Share index, although a 3.5% dividend yield provides an incentive to be patient. An increased focus on recovery stocks and less focus on lowly rated large companies with persistently sluggish corporate performance, such as drugs giant GlaxoSmithKline and HSBC, should bring an improvement to performance.

Other options for betting on recovery stocks

A promising alternative is Aurora Investment Trust (LSE: ARR), which has been managed since the end of 2015 by Phoenix Asset Management. The image of the phoenix rising from the ashes is perfect for recovery investing, but Phoenix's investment process is less encouraging. "We try not to lose money," they say but the downside in recovery investing is often 100% and some mishaps are inevitable. "We only back managements that we trust" is all very well but a clear-out of old management is usually a pre-condition of recovery, and it is hard to trust a new team recruited in a crisis. "We take a great deal of care to invest in businesses we understand thoroughly" but if visibility were not poor and the outlook opaque, the company would not be in crisis. Investing for recovery often requires impetuousness bordering on recklessness, rather than waiting for clearer skies.

Still, Aurora's return of 18.5% in 2017 5.4% ahead of the All-Share index was impressive, and this good relative performance has continued into 2018. Investments just after the Brexit vote in airline easyJet and housebuilders Bellway and Redrow were timely contrarian picks, and retailer Sports Direct is a promising opportunity. Phoenix has recently acquired controlling stakes in micro-caps Hornby and Stanley Gibbons, suggesting an increased willingness to take risk. Perhaps its textbook investment process is not, fortunately, followed too literally.

Buying early is a risk, but don't be too late

Investing directly is a good alternative, but diversification is important, given the risk in each individual share. The best returns will be made where there is a real fear of bankruptcy, but that should not exclude shares such as M&S, Morrison, and engineer Rolls-Royce (everyone's favourite recovery story). Buying too early and seeing the share price continue to spiral downwards is always a risk but waiting for a change of management, a drastic recovery plan and a rescue fundraising can, as Capita and Provident Financial have shown, mean missing out on early gains. Don't expect to buy at the low, and be prepared for some disappointments, even disasters.

But for those with nerve and patience, recovery investing can be hugely profitable while the subsequent bragging rights are priceless.