“Severe market stress and the return of volatility have characterised investing in 2020, in much the same way as we saw in 2009 in the aftermath of the credit crisis. As a result, many of the more cyclical stocks tied to the underlying health of the global economy are priced very attractively”, says RWC Partners’ European fund manager Graham Clapp.
“The time to buy a recovery stock is when all the bad news has already been factored into the share price,” says Clapp. “This is harder than it sounds, but by looking at companies in detail, we try to determine whether the market has been too critical in its assessment. If it has, there is an opportunity to build a contrarian investment case.
“Volatile conditions that have prevailed so far this year can change the opportunity set dramatically. Recovery situations become much more abundant in times of market stress. In effect, it’s time to dust off the 2009 playbook, to see what tarnished treasures can be unearthed.”
When analysing recovery stocks, Clapp believes it is essential to understand what has gone wrong at that business and why, then try to assess what can be done about those problems and what impact the actions of management are likely to have.
“The last time this was the case was in 2009 as equity markets troughed in the aftermath of the global financial crisis. Then, recovery stocks such as ASML, British Airways (now IAG), Rational, Saipem and Temenos collectively accounted for approximately half of our portfolio assets, driving the significant outperformance of the funds we managed during that year,” he said.
“Timing, however, can be tricky. Recovery stocks tend to trough quickly – they don’t typically languish at depressed levels for long. In times of stress, share prices tend to fall quickly and then recover rapidly. This applies as much to entire markets as it does to individual stocks, as the experience of the last six months demonstrates.”
Clapp explains what to look for in recovery stocks when the crucial moment arrives, as he believes it has now. Identifying change is crucial, as is finding those companies that have already had a worst-case scenario priced into their shares.
“Looking for asymmetric risk and reward is key. An investment case is built around what could happen to the share price in different scenarios, ranging from worst- to best-case outcomes. If the share price already reflects the worst-case scenario, then an investor can be confident in their probability of success,” he said.
“Ultimately though, the decision to invest in a recovery opportunity may hinge on an ability to identify change. It helps to have confidence that something will positively influence sentiment towards that stock, be it management or strategy change, business restructuring, or perhaps external influences that will improve demand.
“It helps to already know a business well. Our recovery positions tend to be in companies that we have invested in before. That way we already have a good understanding of the core value of the business, and can build confidence in an investment case quickly to exploit undervaluation while it lasts.”
This also has implications for holding periods and position size, says Clapp: “We tend to hold recovery stocks for shorter periods, sometimes a matter of months rather than years.
“If they do persist as holdings in the portfolio, once the recovery phase of the investment case has played out, they will typically be re-categorised to another segment of the portfolio. At the outset, individual position sizes will tend to be smaller to reflect their relatively high-risk characteristics.”