River and Mercantile Asset Management’s Hugh Sergeant, CIO of equities and manager of the River and Mercantile UK Recovery fund which recently celebrated its tenth anniversary, reveals the key factors he looks for when it comes to recovery investing.
Recovery investing has come into its own in the past decade, becoming as recognised as value and growth styles following the credit crunch and subsequent financial crisis.
Recovery stocks have particular traits investors must look out for. They are companies whose profits are depressed due to either economic or sector dislocation, poor management decisions, or a combination of both, and investors must find those that are poised to turnaround their profitability.
The key is to recognise this potential ahead of the market, aiming to capture the upside in terms of share price gains when said turnaround is recognised.
Nonetheless, recovery investing has always been – and remains – a challenging area for investors, with timing, technology threats and management changes all areas to be considered.
Having launched our strategy a decade ago, there are a number of key pillars of recovery investing which still hold as true today as they did in 2008. Below are our top ten key rules of recovery investing.
SPOTTING RECOVERY POTENTIAL
We define recovery shares as those that have a strong business franchise, a depressed level of profits (and, subsequently, share price) but also ones showing clear signs of being able to grow those profits to a more normal level.
DON’T TRY AND BUY AT THE BOTTOM
When we invest we need to see evidence that things have already started to improve. Investors are always loath to miss out on any upside but it is important to make sure a business has bottomed out and is starting to recover, so we rarely invest in firms until we see signs that the company is in the recovery phase.
MANAGEMENT BUY-IN IS KEY
The catalysts for recovery are most often self-help, and that typically comes from new management, as well as economic and sector stabilisation.
GET THE TIMING RIGHT
Timing is as important as assigning a valuation to a company. One thing we are not is deep value investors, and while value defines how much money you can make, timing decides whether you make that money now or you have to wait two or three years.
A CRISIS IS A RECOVERY INVESTOR’S FRIEND
The more economic or sector dislocation there is, the more recovery shares there are to choose from. Hence the global financial crisis was a particularly opportune time for hunting for recovery investments. Since then we have had the sovereign debt crisis, the implosion of the commodities bubble, Brexit and now the Trump trade ‘war’, all of which have created opportunities.
RECOVERY STOCKS ARE STILL ABUNDANT
It was surprising just how depressed valuations were after the global financial crisis, and how long it has taken for the investment world to recover from it and the ongoing focus on growth companies. Ten years on, many opportunities remain for companies to recover from different events.
UNRESTRICTED INVESTMENT LANDSCAPE
The great thing for recovery investing is that, as long as you are sector and style agnostic, there are always opportunities. Companies’ fortunes will always wax and wane, but as long as there are catalysts for change – something we very much incorporate into our investment philosophy – then opportunities abound.
KEEPING PACE WITH TECHNOLOGY
Recovery investing is about looking for opportunities where businesses are out of favour, but investors have to be very comfortable that the business can indeed recover, and is not in structural decline. The rapid pace of technological change has made this all the more important, as there is a risk investors can overlook the negative impact technology is having on specific industries. While there have always been periods of technological change, the current period is seeing a faster period of evolution than we have seen before.
All recovery investing should assume a buy-in from investors around the length of time they will invest for. Make no mistake; this is not about making short-term gains from oversold stocks, but about businesses implementing fundamental changes to their DNA in order to turn around their fortunes. That takes time, so investors must be patient.
KNOW YOUR UPSIDE
We target a demonstrable upside of 100% over a 3-5 year time frame for every investment we make, but in reality we believe a good recovery share should be a multiple bagger.