Rewards hide in recovery shares

For investors accustomed to the long run of golden years of easy gains in the UK stock market, this year must have come as a shock. The FTSE All Share Index has recorded two successive quarters of decline, the tech boom seems a distant memory and the profits warnings are as commonplace as Japanese knotweed.

For investors accustomed to the long run of golden years of easy gains in the UK stock market, this year must have come as a shock. The FTSE All Share Index has recorded two successive quarters of decline, the tech boom seems a distant memory and the profits warnings are as commonplace as Japanese knotweed.

The dark side of the current low inflation, steady growth business environment is intensifying competition and diminished pricing power. This places more pressure on managements and makes the task of forecasting company profits more difficult. Increasing uncertainty spells problems for investors and demands a fresh approach.

But some dark clouds have a silver lining. The market soon adjusts to the loss of former certainties, marking down the shares of offending companies with a thoroughness that often discounts the perceived increase in risk. The swing of the pendulum invariably goes too far, creating opportunities for canny investors.

The market has also been abnormally polarised over the past year, with frequent changes in investor emphasis. The coming interim reporting season is likely to reveal further corporate weak spots, notably in the hard-pressed bank sector on which the market is focused.

This ferment creates an ideal environment for the contrarian approach. Recovery investing is a well-honed style, which has produced rich rewards by exploiting opportunities shunned by more conventional approaches. By way of illustration, £1,000 invested in the M&G Recovery Fund at launch in 1969 would now be worth £191,200. Out-of-favour companies or those with perceived problems usually stand on sub-market valuations.

They make ideal takeover candidates for corporate predators, who, like recovery specialists, are prepared to seize the opportunity to acquire good quality assets whose value is being overlooked by the market. Recent takeout prices in the cases of Burmah Castrol, Charter and Thomson Travel, have been at substantial premiums to levels prevailing immediately before bid action. This is set to continue.

The starting point of successful recovery investing is the ability to distinguish fundamentally unattractive companies in declining industries from those which are basically sound, but have short-term problems. In the latter case there is usually a strong business or brand which has been under-exploited or mismanaged; surgery and repositioning by new management often produces good results. Well-known large companies which are at various stages of a relaunch under new managements include Barclays, British Airways, Marks & Spencer and Reed International.

The recent neglect of Old Economy stocks has produced unprecedented buying opportunities. Assessing these requires a well-developed investment process, willingness to carry out thorough research and ready access to senior company managements.

Broad categories meriting further investigation include good-quality industrials, the banks and even certain fallen angels among the once highly favoured tech sectors. In general, small and medium-sized companies provide a disproportionate number of potential prospects, reflecting relative neglect by investing institutions and the consequences of their more limited marketability.

Recessions are usually the ideal buying time for recovery fund managers. Today, potential buying opportunities arise from market conditions, rather than the macro-economic background.

John Hatherly is head of Global Analysis at M&G. Derek Pain is on holiday