To say that M&G Recovery fund has a long term record is something of an understatement. Launched in 1969 it has an esteemed longer-term history of outperforming the market and was the first investment of its kind.
A fund that looked beyond the glamour and excitement of the largest, most successful companies, instead looking for potential gems in the stock market rubble; Firms widely maligned, down on their luck or experiencing operational and financial challenges that many investors assumed were insurmountable. In short, backing the underdog to make an unexpected comeback.
Why seek to do this? Why not focus on good-quality companies? Those whose future is likely secured and whose growth can be relied upon. Of course this is a perfectly valid strategy, and one many successful investors follow. However, these sorts of companies are unlikely to be found at inexpensive valuations. By rummaging through the stock market’s bargain basement it is possible to find shares that can rise many-fold should corporate recovery occur, especially if the company in question is deemed to be on the brink of disaster.
Recovery, of course, is far from assured. Companies that have been shunned by the market may have serious challenges that cannot be resolved. It is not unusual for things to go wrong, for a company to never recover or, even worse, to go bust losing investors all of their investment. Yet by having great patience, more winners than losers, and, if necessary, providing help in the form of third party expertise and finance M&G Recovery has enjoyed some fine periods of performance.
Amazingly, it has been run by only three different managers throughout its history, the latest being Tom Dobell. He has refined the fund’s process a little since taking over in 2000, but the fund very much remains true to its original principles.
In recent years it is fair to say the fund has struggled. Although 2016 was a strong year, it underperformed the FTSE All Share Index in each of the previous five. Although stock picking mistakes were certainly made during this period, a significant reason was market sentiment.
Following the global financial crisis in 2007/08, the financial landscape was shaped by low interest rates and quantitative easing, which served to depress bond yields (and push up prices). In this low interest rate, low inflation and perceived low return environment investors became risk averse, favouring safe-haven bonds and stocks with “quality” characteristics such as strong market positions and dependable earnings – areas of the market where the fund had very little exposure.
According to Dobell, material operational progress for many of his portfolio holdings was widely ignored by the market until the mood changed last year. To him, the change in direction of bond yields that occurred at around the same time is no coincidence. Investors began to rethink their expectations of low growth and inflation, adopting a different approach to risk which resulted in a more conducive environment for the fund.
Not only were investors more inclined to consider economically-sensitive areas where the fund has significant exposure, but appetite for merger and acquisition activity increased, shining the spotlight on some of the unrealised potential in the portfolio.
A case in point is Lavendon, the European market leader in the rental of powered access equipment – or, more colloquially, “cherry pickers”. According to Dobell, the market had given little credit to management turning the business around, but following a number of bids from overseas buyers the shares more than doubled in value in the space of two months.
It illustrates there are times when private buyers see value even though the market doesn’t. There may well be similar situations for other companies in the fund yet to unfold.
The recovery process inevitably means that few investments go smoothly, though. Some require great patience or additional money through refinancing, or both. Kenmare Resources, a minerals mining company operating in Mozambique has languished in the fund’s portfolio for 15 years.
However, now it is free from debt Dobell is confident the business can thrive. Similarly, Enterprise Inns, the owner of thousands of UK pubs, was long overshadowed by a huge debt pile and has been a portfolio constituent for longer than expected. Dobell generally views the recovery process as taking five to six years typically, but this seems to have been extended in recent times.
As companies in the portfolio move through the recovery “cycle” Mr Dobell tends to takes profits as the share price rises and the company becomes a larger constituent of the fund. He then sells completely when he deems the process complete and full value is recognised by the markets, recycling money into new opportunities.
However, these decisions are made on a case by case basis. For instance, GW Pharmaceuticals is a business in a more mature stage of the recovery process in the portfolio. The company has successfully developed an epilepsy drug and has already proved a lucrative holding. However, Dobell is holding on for more, anticipating the drug will sell better than supposed by others, and looking for the potential for further drugs to add to profits.
Recovery situations make for esoteric, unpredictable and sometimes highly volatile investments. While this fund’s performance has on occasion given us cause for concern – and tested our patience in terms of retaining the fund on our Foundation Fundlist – it has stuck rigidly to its principles in attempting to identify where the market has misinterpreted or mispriced the risk of companies in challenging situations.
With a more favourable environment of stable or rising bond yields, and the possibility of additional impetus from greater merger and acquisition activity, there could be significant value in the portfolio to be realised going forward. We therefore believe it makes for an interesting holding, and one that offers significant diversification from more mainstream funds.
Rob Morgan is pensions & investments analyst at Charles Stanley Direct.