Special situation funds should, in theory, be busy making new investments in the current market environment. Their strategy includes finding unloved stocks which could either bounce back thanks to corporate self-help measures or the market eventually spots hidden value within a business which then attracts more buyers for the shares.

Given how so many stocks have slumped in value this year – many for no reason beyond negative investor sentiment in general – there should be plenty of opportunities for special situation fund managers.

Therefore, anyone looking to take advantage of 2022’s market weakness might want to look at these types of funds as they are likely to be building positions now which could drive returns over the coming years, assuming markets recover.

WHAT DO THEY INVEST IN?

‘Special situations’ is a term mostly associated with recovery stocks, companies in urgent need of a refinancing or suffering from investor indifference, although this style encompasses much more than mere recovery investing.

Special situations funds are meant to be ‘benchmark agnostic’, meaning they can make concentrated, conviction trades which take them away from the index.

They also have licence to invest in mid, small and micro cap stocks if the manager thinks that’s where the opportunities are. Though the majority of special situations funds are value biased, not all are, so here’s a flavour of what they do.

Jupiter UK Special Situations (B4KL9F8) is one of the better known funds in this space. It is managed by seasoned value manager Ben Whitmore, whose team uses statistical techniques to screen companies for certain characteristics, narrowing their search for the best value opportunities.

Artemis UK Special Situations (B2PLJQ0) looks for companies that have a degree of self-determination – those where there is a degree of internal change that can act as a value creator and offset any macro headwinds.

Co-manager Derek Stuart says: ‘Such value creation may come through capital allocation (disposals, acquisitions, debt paydown), overall improvements in margins and returns, improved business focus and efficiencies.’

Stuart points out that if the business has historically been an underachiever, then a new management team acts as the catalyst for rehabilitation.

‘Recent examples of management change stories are Babcock (BAB), Burberry (BRBY), C&C (CCR), Restaurant Group (RTN) and Smiths Group (SMIN),’ he adds.

The fund manager also looks at companies where exceptional external events have impacted short-term performance. ‘For instance, the hospitality and airline sectors during the pandemic when we acquired positions in Jet2 (JET2:AIM), JD Wetherspoon (JDW) and WH Smith (SMWH).’

YOU GOT THE WRIGHT STUFF

One of the UK’s best-known contrarian investors is Alex Wright, portfolio manager of the Fidelity Special Situations (B88V3X4) fund and its sister investment trust Fidelity Special Values (FSV). According to FE Fundinfo, these products have delivered 10-year total returns of 132.3% and 235.8% respectively.

Wright says: ‘Our focus is on companies that have gone through a period of underperformance but where there are signs of positive change coming through’.

This can be internal change, for example a new management team or restructuring, or external change such as shifting industry dynamics or shrinking competition, ‘and preferably both’, says Wright, adding that the stock market tends to be inefficient at pricing companies that have gone through a troubled period and are consequently out of favour.

‘Unloved companies, especially if smaller caps, are not well covered by analysts,’ he explains. ‘The lack of research can often combine with market scepticism to leave many companies trading below the true value of their franchise.’

Wright places strong emphasis on understanding the downside risk of each potential investment. ‘Chosen investments exhibit an asymmetric risk-return profile, where the potential for future upside in the price of a stock far exceeds the prospect for further declines,’ he explains.

Investing across the market cap spectrum, Wright’s portfolios are ‘fairly differentiated’, a good thing as there is ‘less competition, not just for flows, but also in terms of the types of stocks we look for. It is much harder to add stock specific, idiosyncratic alpha if one is just doing the same thing that other investors are doing.

‘In contrast, if one is looking at a sector that has been overlooked and where there is much less competition, one stands a very good chance of finding those hidden gems that can add significant value.’

Wright’s funds do have a value bias, but a key difference to peers is that he doesn’t just look for cheap stocks but also evidence of positive change. Leveraging Fidelity’s team of equity analysts worldwide, Wright conducts thorough due diligence and investigates the potential catalysts for change and the likelihood of the change coming through.

‘This is a very research-intensive process, which involves not only talking to the management teams, but also competitors, customers, suppliers, industry experts, and considering global industry trends in order to build a 360 degree picture,’ he says.

Another fund from the Fidelity stable is the £3 billion Fidelity Global Special Situations (B8HT715). It invests in companies which managers Jeremy Podger and Jamie Harvey believe to be undervalued with recovery potential not fully recognised by the market.

They focus on three specific categories of companies. These are corporate change – businesses undergoing change via restructuring, M&A or spin-offs; exceptional value – companies with the ability to deliver earnings growth in excess of market expectations and enjoy a re-rating. And unique businesses – typically firms with a dominant industry position, strong growth, cash flow and pricing power.

The approach has paid off handsomely as Fidelity Global Special Situations has delivered a 10 year total return of 245.7%. That is slightly less than the 273.6% generated by investment trust Fidelity China Special Situations (FCSS), though the trust is down 32.2% over one year due to the sell-off in Chinese stocks triggered by fears over slowing growth, regulatory crackdowns, rising geopolitical tensions and the return to a zero-Covid policy.

In this case, special situations refers to Chinese companies which manager Dale Nicholls believes to have good long-term prospects, cash generative business models and strong management teams, yet whose strengths are not well understood by the market and not reflected in valuations. Nicholls also focuses on Chinese smaller companies as these tend to be less well researched and, therefore, more mispriced.

Other constituents of the special situations universe include Richard Penny’s TM Crux UK Special Situations (BG5Q5X2) fund, up 25.3% over three years. Penny searches for companies in the recovery ward, which are refinancing, are subject to management change or boasting strong potential growth, and seeks out firms that hold undervalued assets.

DURABLE COMPETITIVE ADVANTAGE

A special situations fund with a different, though very successful, approach is Liontrust Special Situations (BG0J268). Managed by Julian Fosh and Anthony Cross, this vehicle aims to deliver long-term capital growth using Liontrust’s ‘Economic Advantage’ process.

This seeks to identify companies that possess intangible assets which produce barriers to competition and provide a durable competitive advantage that allows them to defy industry competition and sustain a higher than average level of profitability for longer than expected.

Fosh and Cross believe the hardest characteristics for competitors to replicate are three classes of intangible asset: intellectual property, strong distribution channels and significant recurring business.

Other important intangible strengths include franchises and licenses, good customer databases and relationships, effective procedures and formats, strong brands and company culture.

WHAT ARE THEY BUYING?

Fidelity’s Wright has been adding to banks including Barclays (BARC) and Close Brothers (CBG), with the sector now speaking for about 13% of his portfolios.

Wright notes that the banking sector typically sees profits hit in downturns, but today banks have strong balance sheets and consumers are in a much healthier position compared to prior recessions. ‘Employment is high, wages are rising and households still have savings from the pandemic,’ he explains.

He added to Barclays as the lender was ‘trading at crisis-like levels’ despite delivering a solid return on tangible equity.

‘Banks such as Barclays will not only benefit from rising interest rates, but also from expanding loan books at a time when most consumers and large corporates have ample ability to borrow and may need to do so to meet rising costs.’

Wright describes Close Brothers as ‘a conservative, well-managed, returns-focused niche lender’. He says it won’t benefit from rising rates, as it has no current account business, but because of this situation the stock had underperformed and was trading below book value.

‘Both stocks also benefit from some counter-cyclical revenues (i.e. revenues strongest when there is high volatility) – Barclays through its investment banking business and Close Brothers through its retail brokerage arm.’

Artemis’ Stuart says there were reasons why he invested in JD Wetherspoon. ‘Ultimately when the pandemic ended we expected people to revert to their old habits and go to pubs and trading to normalise. But we expected the pandemic to have a longer-term impact too – clearing out some capacity and enabling Wetherspoons to take market share.

‘Surveys suggest that over 10% of pub capacity has gone from the UK pub market,’ adds Stuart. ‘The current inflationary environment puts more pressure on the smaller operators and again forces reduced capacity. The British Beer and Pub Association currently estimates that only one in three hospitality venues is currently profitable.

‘We believe that Wetherspoons, as a larger player, is better placed to weather this storm and should come out with greater market share and ultimately more profitability.’

‹ Previous2022-08-11Next ›