Go anywhere, buy anything, say market's adventurers

Special situations funds are the adventurers of the fund management world. Their managers take a contrarian view, seeking out lowly valued companies that most investors avoid. While this approach sounds risky, such bravery can pay off; four of the top 10 funds set up in the UK over the past seven years are special situations products.

Special situations funds are the adventurers of the fund management world. Their managers take a contrarian view, seeking out lowly valued companies that most investors avoid. While this approach sounds risky, such bravery can pay off; four of the top 10 funds set up in the UK over the past seven years are special situations products.

Moreover, special situations funds come into their own in certain investment conditions. And today's difficult market may be the ideal time to invest.

After four years in the doldrums, share prices finally seemed to be recovering during the first two months of the year. The FTSE 100 index of leading shares even broke through the 5,000 mark at the end of February - nowhere near the high point of 6,995 reached on the final day of 1999, but well above the low of 3,287 at the end of 2002.

However, the recovery already looks like a false dawn. The Footsie is now back down to about 4,800, with a string of big losses from shares in well-known companies. That leaves investors with a dilemma: do they pull out of equities altogether - and risk missing out on an upturn - or leave their money in a struggling market?

Investment experts are united in their view that this is a "stock-picker's market". What they mean is that investors who buy into funds that have a very broad spread of holdings - such as index funds, which move in line with the market as a whole - are likely to end up disappointed. Instead, the funds to look for are those where managers actively hunt down a smaller number of shares they believe are likely to buck the general market gloom.

Rob Harley, of independent financial adviser Bestinvest, says this is the whole point of a special situations fund. "These funds are good at chiselling out value when markets are trading sideways," he says. "People describe them as risky, but that's unfair because they're only aggressive in the sense that they take different positions to most managers, and the 'go anywhere, buy anything' mandate may be exactly what is needed in this sort of market."

Anthony Bolton, who celebrated 25 years at the helm of Fidelity Special Situations in December (see below), describes his approach as "general contrarian". He explains: "I focus on mis-valued securities, buying unfashionable companies. I don't manage my stock and sector weightings according to a benchmark - exposures are the result of stock selection."

In practice, special situations funds can end up with a diverse portfolio of large, medium-sized and small companies. The company might be from any industry or sector: the fund manager just needs to see evidence that the market has undervalued it for some reason - and that there is a chance of a re-rating at some stage in the future.

Derek Stuart, the manager of Artemis's well-regarded UK Special Situations Fund, says: "There is always something to buy and sell. I'm actually really excited about this year because when investors are nervous, any negative news has a disproportionate effect on prices and that gives us opportunities to exploit."

Stuart is currently considering investing in the specialist retailer Games Workshop, for example. He says the company is very well run with a good future, but a profits warning last month knocked its price down from about 750p to 450p, which is exactly the sort of over-reaction for which special situations funds search.

Over the long term, these opportunities can pay off. An investor who put £1,000 into Fidelity Special Situations 10 years ago, for example, would now have a stake worth £4,767. The same investment in the average UK fund, which has moved broadly in line with the market as a whole, would be worth only £2,125.

The comparison goes to the heart of the appeal of special situations, says Darius McDermott, of the independent financial adviser Chelsea Financial Services. "In this environment, you need a fund that can do anything to find value," he says. "Also, remember that you'll pay the same 1.5 per cent annual fee for the average fund as most special situations funds charge. Why should you pay this for a product that just follows the stock market?"

Special situations funds don't just look for companies that are down on their luck. The focus on undervalued shares also leads them into the same territory as predators looking at takeover targets. The mergers and acquisitions market in the UK has been buoyant this year, with speculation about takeovers of everything from Manchester United football club to Boots.

When investors spot a takeover target before a bid emerges, there are excellent gains to be made. The biggest winner on the UK stock market since the general tide turned at the end of February has been Allied Domecq, where the share price is up by more than 25 per cent. The gains follow its agreed takeover by Pernod Ricard.

Ben Yearsley, of the independent financial adviser Hargreaves Lansdown, says: "Fund managers who hold bid targets are well rewarded, though it's a risky strategy because you can wait an age for a bid to emerge."

Like his colleagues, Yearsley believes special situations funds are well-placed to make good ground in the current market. But he also suggests investors consider a new type of fund, set up in recent years with a similar brief. "Dynamic funds and focus funds also try to spot stocks particularly likely to outperform, though they may have fewer holdings than a special situations fund."

Ajay Gambhir, who heads up the dynamic fund range launched by JP Morgan Fleming in 2000, says his products share some characteristics of the special situations sector. The point, he says, is to get away from the constraints that most fund managers work under.

"If you don't like BP, say, you shouldn't have to invest in it just because it represents 7 per cent of the UK stock market, but most managers have to own the company," he says. "That said, investors in all these funds have to accept they are taking a risk relative to the market. Their funds won't necessarily perform in line, though that may be no bad thing."

Check fund managers' individual objectives carefully. In practice, special situations funds generally include those described as "aggressive" or "select" by their managers. Dynamic funds and focus funds tend to carry these descriptions in the name. But, as in all cases, individual managers work differently.

Bolton has a sharp eye for something with that special value

Anthony Bolton was appointed manager of Fidelity Special Situations at its launch in December 1989. Sixteen years later he's still in charge at the fund, which has outperformed the stock market as a whole in each of the past five calendar years.

The fund's brief is a classic special situations mandate. "I try to find undervalued companies that are currently out of favour with the majority of investors, but which are likely to capture investors' interest on a one- to two-year timescale, resulting in a higher price," he says.

Right now, Bolton has about 190 holdings, with each stock typically held for between one and two years. Although his largest stakes are currently in BP, the gas group BG and Standard Chartered Bank, the fund is balanced. "I tend to find more investment ideas among medium-sized and smaller companies," Bolton says.

Cairn Energy, the fund's fifth-largest holding, for example, is not even a member of the FTSE 100 index of shares.

All of the stocks fit into one of five key areas of interest: industry anomalies, recovery situations, unrecognised growth, attractive assets and corporate potential.

Anomaly plays include Allied Irish Banks, for example, where the valuation is out of step with the sector. ITV, which is still getting over various crises, is a good example of a recovery stock, while Bolton suggests the bookmaker William Hill as an example of the type of company where growth is going unrecognised.

Property companies John Laing and British Land fall into the attractive assets category, while Bolton suggests Rank Group and Capital Radio as two companies where there is scope for some sort of corporate action to boost the shares.

Bolton says exhaustive research is the only way to run a special-situations fund. "I see one or two companies every day and I keep notes on every company meeting I have attended in the past 15 years," he says.

The fund is up by 376 per cent over the past 10 years, and by 12.5 per cent over the past 12 months. As a result of this impressive track record, money has poured into Fidelity Special Situations, which is now valued at £4.5bn.

Bolton's task for the future is to make sure he can continue to find value while managing such an enormous pool of assets. But he is cautious about the market's prospects. "Investors are becoming more confident about the global economic outlook," he says. "The market is unlikely to peak without greater private investor participation."

Expert tips

BestInvest's Rob Harley says Anthony Bolton's Fidelity Special Situations Fund continues to be the sector's pacesetter. Alternatively, Harley praises Derek Stuart's fantastic record at Artemis UK Special Situations ­ it is worth £588m, enabling it to be much more nimble than the giant £4.5bn Fidelity fund. In addition, he tips Framlington UK Select Opportunities. It is now run by Nigel Thomas, who previously had an excellent performance track record at ABN Amro.

Hargreaves Lansdown's Ben Yearsley also tips the Artemis and Framlington funds. In addition, he likes Invesco Perpetual's UK Aggressive fund, which has performed well since its launch in 2003. Darius McDermott of Chelsea Financial Services tips Framlington and Fidelity. His third choice is Rathbone Special Situations.

One other fund worth investigating is Marlborough Special Situations, the best performing of all UK-based unit trusts over the past seven years. The fund invests predominantly in smaller companies so it sits in a different sector to most rivals.