The return of recovery investing

The announcement of the elevation of IMI to the FTSE 100 index came as a complete surprise to me because I had forgotten all about it. Short for Imperial Metal Industries, it was a mid-cap “metal basher” in the 1990s, having been spun out of ICI in the 1930s. 

Now, it seems, IMI is a specialist engineering business that “looks for ways of solving industry problems that have an impact on everyday life” in areas such as industrial automation, fluid control and energy efficiency. Its shares have risen by over 40% since mid-2022, but, on a multiple of less than 15 times this year’s earnings, still look good value. 

Investing for recovery was a winning strategy in the 1980s and 1990s. It is not to be confused with value investing, which implies buying shares that are cheap because the companies, though reasonably well-run and cash generative, have limited – if any – growth prospects. 

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That, in theory, makes them low-risk. Recovery investing involves buying into companies that have tripped up – resulting in a slump in profits, a collapsing share price, new management, cost-cutting, and a lower dividend. 

Investing in such companies is highly risky because their fortunes can get much worse before they get better. Turnarounds are difficult; they take time and regularly fail. IMI belongs in a second category: companies that transform themselves into a business with better prospects through investment, disposals and acquisitions. 

This, clearly, is also risky, but potentially rewarding for investors. A more conventional recovery story may be unfolding at outsourcing specialist Capita. It is being promoted to the FTSE 250 mid-cap index, having once been a FTSE 100 constituent. 

Capita’s share price peaked at nearly £8 in 2015, but dropped to barely 20p late last year. Now, under new management, growth has returned, the firm is cash-generative, and the shares have risen by nearly 50%.

From doghouse to darling

Fellow outsourcer Serco has been in the doghouse since 2013, when its share price fell by 80%, but it too is showing promise. Sales, profits and cash flow are rising, the company is buying back shares and the stock is 50% off its lows, trading on barely ten times 2022 earnings. 

BAE Systems was the FTSE 100’s best-performing share in 2022, appreciating by 56%. This was widely attributed to the benefit to BAE of Russia’s invasion of Ukraine. 

But although this was clearly good for business, the company had been performing well already, with the share price multiplying in value over nearly 20 years. In the 1990s, it had a crisis, firstly from having bought but mismanaged the Rover car group and secondly from having tried to corner the declining market for UK defense procurement. 

Last year’s second-best performer, up 53%, was another casualty from the past. In the 1990s Pearson transformed itself through some very expensive acquisitions from being a conglomerate including media and finance to becoming a specialist in educational services. 

The share price crashed with the dotcom bubble in 2001-2003 and has seen no sustained recovery since, despite 2022’s performance. 

Now, its business is threatened by artificial intelligence (AI) and true A strategy based on finding stocks poised for a turnaround may be making a comeback, says Max King recovery looks as far away as ever. 

Vodafone, Glaxo, British Telecom, BP and most of the financial sector also expanded through overpriced acquisitions in the late 1990s, fell flat on their faces in the early 2000s, and have struggled ever since. 

The dismal subsequent performance of these once mega-cap companies hampered the overall showing of UK equities and discredited the strategy of investing for recovery. The signs that this is changing are growing as investors lose patience, predators come sniffing and management realise that complacency is not an option. 

The appointment of Archie Norman (who had previously turned around Asda and ITV) as chairman of Marks & Spencer in 2017 led to hopes of a change in its declining fortunes, but it has been a slow process.

Not just a rebound, an M&S rebound

Four years ago, M&S, which had previously disdained online shopping and home delivery, announced a joint venture with Ocado. M&S acquired 50% of Ocado’s retail business for £750m and, in return, Ocado would deliver M&S products, both groceries and its non-food lines. 

M&S financed the transaction with a £600m rights issue, but many believed that it had overpaid, so its shares fell back below £1 last autumn. Ocado was the FTSE 100’s worst-performing share last year, falling by 63%, but M&S’s shares have nearly doubled in eight months thanks to strong results. 

Sales in the year to 31 March 2023 grew by 10%, with the clothing and home division outperforming food, and profits were up by over 20%. M&S has at last got its fashion ranges right, has sorted out its logistical problems, closed underperforming branches while opening new food stores, and benefited from the Ocado tie-up. 

After numerous false starts, recovery is for real. Last year GlaxoSmithKline (GSK) spun off its consumer health business, Haleon, in order to focus on pharmaceuticals. After an early wobble, Haleon has performed well, but it is too soon to say if the strategy is paying off for GSK. 

It has cut its dividend by 31%, but expects a return to growth in both sales and profits. Perhaps it has been stung into action by the success of AstraZeneca (AZN), whose share price has more than doubled in the last five years while GSK’s has fallen. 

With growing sales and a promising pipeline, AZN now has a market value more than three times that of GSK, having been smaller just ten years ago. BT has been another long-term lame duck, but the plan to reduce its workforce by 40% by the end of the decade suggests it has been stung into action. 

Rolls-Royce is also said to be planning job cuts as it seeks to turn itself around at last. For too long, it has seen itself as a national treasure rather than as a business needing to deliver returns to shareholders.

British Airways is taking off 

BA’s owner IAG was also hit hard by Covid, but announced an unexpected profit in the first quarter. Falling fuel prices, uptake in leisure travel and demand from premium leisure travellers are compensating for weak demand from the business sector. 

The broader dilemma for investors is whether to invest early, when the evidence of a lasting turnaround is scant, and risk waiting for years for the payoff – or wait for clear progress, by which time the stock may well have risen substantially. 

A good option would be a specialist, contrarian trust. But since Alastair Mundy left Temple Bar to become a maths teacher three years ago, there has been no obvious candidate. 

Temple Bar and Edinburgh Investment Trust have both performed well over three years, but been average over one. Their top-ten holdings do not include the eyebrow-raising names of a Mundy portfolio, which probably means they are being too safe. 

BP and Shell did well last year, but are in the crosshairs of politicians, media and public opinion. The business model of UK banks, based on lax regulation, a branch network and investment banking, is broken, not least by the competitive threat of internet banking. 

British Aerospace and AstraZeneca are mature as recovery stories. Tesco operates in a very competitive market and Pearson is still struggling. Centrica is a mature utility. These portfolios offer a mixture of income, value and “growth at a reasonable price”, but not much recovery. 

This is a pity, because if the UK market is to pull out of its long-term downward spiral, it will be because corporate management is stung into action by its shareholders, by peer pressure and by the prospective reputational and financial rewards of success, not because of any actions by politicians or regulators. Investors with a taste for recovery and the appetite for a bit of risk will just have to invest directly.