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The best bounceback candidates on the UK market

With the UK economy seemingly headed for a ‘soft landing’ and interest rates set to fall at some point this year, more adventurous investors will be looking to add a little more risk to their portfolios.

Given the UK market, and the mid-cap space in particular, is widely acknowledged to be cheap, the passive option would be to buy a mid-cap ETF (exchange-traded fund) such as the iShares FTSE 250 (MIDD) or the Vanguard FTSE 250 (VMIG).

However, for those wanting to take a more active approach or those looking for stocks which are cheaper still than the market, picking a manager with experience in the field is probably a better option.

There are a handful of ‘recovery’ or ‘special situations’ funds which focus on investing in companies whose shares have been beaten down, usually due to temporary difficulties, but which have the capability to bounce back generating large returns in the process.

THREE OF THE BEST

Probably the best-known funds in this sector are the Fidelity Special Situations Fund (B88V3X4) and the Jupiter UK Special Situations Fund (B4KL9F8).

Both are run by highly-experienced managers, Alex Wright at Fidelity and Ben Whitmore at Jupiter. Both are rated four-star by Morningstar and sit at the higher end of the risk spectrum, and both have beaten the FTSE All-Share total return index and the IA (Investment Association) All Companies index over one, three and five years.

The Jupiter fund has been around longer, having been launched in 2006, but the Fidelity fund is larger at roughly £3 billion against £1.5 billion.

The make-up of the two is also quite distinct with very little cross-over, despite both having more or less the same brief, which is interesting.

Slightly smaller and therefore possibly less familiar to readers, but considerably older than both of these, is the £900 million Schroder Recovery Fund (B3VVG60), which was launched way back in 1970 and is currently managed by Andrew Lyddon and Nick Kirrage.

With a brief to invest in UK stocks which have suffered ‘a severe setback in either share price or profitability’, the fund has comfortably beaten the FTSE All-Share and the IA benchmark over one, three and five years.

OPPORTUNITY KNOCKS

Alex Wright explained to Shares how he manages both the open-ended Fidelity Special Situations and the closed-end sister fund Fidelity Special Values (FSV).

‘Our portfolios aren’t buy-and-hold strategies, a key part of our investment process is to be constantly on the lookout for new opportunities as well as remaining disciplined and taking profits in stocks which have performed well and where the risk/reward is no longer as attractive.’

Financials are strongly-represented in the Special Situations fund – as well as their attractive valuations, UK banks have seen a positive impact on their profitability from higher interest rates, while life insurers have benefited from an acceleration in the pace of pension de-risking and non-life insurers are enjoying better pricing and a moderation in the cost of claims.

‘Another area where we continue to find opportunities is defensives, where we have added to the likes of Reckitt Benckiser (RKT), BAT (BATS) and National Grid (NG.) on weakness,’ says Wright.

He cites last month’s Labour general election victory as a further catalyst for adding to National Grid: ‘The stock would be a key beneficiary if the newly-elected Labour government increased the speed of the build-out of renewables as they hope to do. The company is very much part of the solution in terms of the need for more investment, and thus far less likely to be targeted as source of tax revenues.’

On the flip side, Wright and co-manager Jonathan Winton reduced their North Sea oil and gas exposure in response to the fact Labour doubled down on their removal of the North Sea investment allowance which clearly hurts that sector.

‘CONTRARIAN’ INVESTING

Jupiter’s Ben Whitmore describes his ‘contrarian’ approach to investing as hunting in unpopular areas of the market, looking for companies where the valuation of their assets, cashflows or profits is low, as consistently applying that same discipline to generate above-average returns over the long term.

‘In the short term, the market is driven by human emotion so we’re always looking in areas which people have shunned and are out of favour for temporary reasons.’

Whitmore admits his strategy doesn’t work every year, and there can be difficult periods, but as long as the price paid reflects the quality of the business then over time valuations will recover.

‘We don’t think it’s possible to think of quality or valuation on their own. For us, good value can be either an above-average quality company trading at an average valuation, or a below-average quality company at an absolute bargain price. We’re always thinking about that trade-off.’

In the year to March 2024, the fund added to new positions in Anglo American (AAL), Burberry (BRBY), Johnson Matthey (JMAT) and Reckitt Benckiser among others.

‘In each case, the stock market has a very cautious valuation either due to worries over the economy or a particular concern about the individual company. We think these low valuations offer a compelling risk/reward,’ says Whitmore.

The purchases were funded by the complete sale of positions in BAe Systems (BA.), BT (BT.A), Intel (INTC:NASDAQ), Kyndrel (KD:NYSE), Moneysupermarket (MONY) and South32 (S32).

‘MEANINGFULLY UNDERVALUED’

Schroders managers Lyddon and Kirrage believe the ‘material’ outperformance of growth companies, and those associated with AI (artificial intelligence) in particular, is unsustainable and ‘the next decade is likely to see a reversal of these trends with the cheapest parts of the market meaningfully undervalued versus their long-term histories’.

‘In the past few years, when fear has taken hold, we have witnessed some rapid sector and market cap rotations,’ adds investment director Andy Williams.

‘Sometimes, we are compensated for running into a burning building,’ says Williams, using the example of insurer Direct Line (DLG) which was caught out by a combination of higher-than-expected claims inflation and regulatory change which put pressure on its capital position.

The firm let go of its chief executive and cut its dividend to save cash, sending the shares skidding, but by subsequently selling its Commercial Insurance business for an impressive multiple of profits, alongside several smaller capital generation measures, its capital strength improved significantly.

As profits recovered and dividends restarted, the shares recovered strongly helped by a bid approach from an overseas competitor who understood the long-term attractions of the company.

‘Making uncomfortable decisions today sows the seeds of outperformance tomorrow,’ maintains Williams.

During the second quarter of 2024, the Recovery Fund continued to outperform the IA sector and its benchmark thanks to contributions from energy services businesses Hunting (HTG) and Wood Group (WG.), the former on a record contract win and the latter on a bid approach.

Royal Mail-owner International Distribution Services (IDS) was another winner thanks to bid interest, while BT, Barclays (BARC) and NatWest Group (NWG) performed well on their results.

Interestingly, the managers established new positions in Burberry and Johnson Matthey, in line with Jupiter’s Whitmore, as well as adding low-cost airline easyJet (EZJ) to the portfolio.

Iron ore pellet producer Ferrexpo (FXPO) was sold to make way for the new arrivals, along with facilities management company Mitie Group (MTO).

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