Bouncebackability

Spotting recovery value

The good news for investors alert to the prospects of recovery is that, even against the backdrop of a recovering economy, there will always be companies that, whether through mismanagement or structural changes to an industry - or, as is arguably the case for Trinity Mirror under Mr Fox's predecessor Sly Bailey, both - will suffer depressed share prices. Industries always have their losers and laggards. And for investors who know what to look for, it's a good way of making multi-bagger style returns like Trinity, up nine-fold since its low of 25p in mid-2012.

However, it's also a risky approach for the uninitiated. It's not simply a case of pumping money into shares that have fallen precipitously in the hope of a bounceback. You have to work out the reasons why a share will bounce back, because many troubled companies are simply too broken to recover. One obvious lesson lies in JJB Sports, which called in the administrators in 2012 after a drawn out four-year recovery saga that involved Bill Gates, the Serious Organised Crime Agency and a circling vulture in the form of Sports Direct (SPD). Its shareholders ended up with nothing despite pumping tens of millions more into the group as it fought for survival.

Retail failure

More often than not, such companies will have borrowed far too much money, often because they've over-expanded without fully considering the possibility of a cyclical or structural downturn in the future. In the case of retailers such as JJB, it's not necessarily debt in itself that's the issue, but liabilities - usually in the form of trade creditors and landlords; quarterly rent day - when three months rent is paid in advance - is a notorious black spot for struggling shops. The upshot was that over-confident retailers such as JJB or Game Group simply had too many outlets signed on long leases. Having merged with its largest rival, Game, for example, had over 600 UK stores at its peak. Such costs often can't be cut quickly enough - unlike recruiters, who were able to slash costs in the wake of the credit crunch, before hiring again to stage a strong comeback as the cycle turned up again in 2013.

Even these particularly ugly retail bankruptcies serve as a reminder that companies don't shut off the lights due to large amounts of debt - creditors, after all, want their money back. Instead, companies that go bust due to debt are the ones unable to generate enough cash to pay it back and keep the business ticking over with working capital at the same time.

For companies like retailers with large trading liabilities, things can look like they're going very well indeed until trading starts to slow - as was the case with Game Group, a stock market star that quickly unravelled when sales plunged in the absence of must-have new console launches (also a reminder that a company's recovery may be largely out of its own hands - Game had little influence over the development plans of Sony or Nintendo, or indeed the supermarkets that were muscling in on its territory).

Retailers' lease liabilities are also a reminder that you need to look not just at debt, but how debt and other liabilities are structured and the covenants in place - often trading-related criteria that would allow a bank to call in its loans. And investors should pay attention to how much headroom a company has between its debt and credit facilities, because the smaller that gap is, the more pressure there is to generate cash. If cash flow becomes a problem, the company could be forced into a rights issue, a placing or an open offer to pay down debt.

Retailers can make difficult recovery plays as a result - short visibility makes forecasting difficult, and they're often dependent upon an inspired change of strategy. But in other sectors a company with enormous debts could still be trading its way out of trouble by winning new business. Bulging forward order books are often an encouraging sign, even if current sales and profits look weak.

It's the industry, stupid

The first anything a bounceback-spotter should do is try and understand the industry trends that damaged the companies in the first place and whether a company's business model remains viable. Very often, the recovery candidate may have been slow to respond to a disruptive technology or trend. HMV is a good example of a company that simply left it far too late to respond to structural industry changes, in its case the shift in media sales online, via e-commerce and downloading. By the time the investments were made, it was too little to late to take on the might of Amazon.

There are similarities between HMV's and Trinity Mirror's problems. Print publishing, like physical media sales, has been a widely publicised victim of the internet age and the rise of digital media. At Trinity Mirror that resulted in eight years of falling print circulations and a shift of advertising budgets to digital channels.

The news business isn't getting any easier, either - the New York Times reported a 54 per cent drop in net income last quarter, citing falling advertising sales, flat circulation revenues and a step-up in digital investment. However, the industry has, after a somewhat stalled start, embraced digital. And unlike HMV, which distributed other people's content, publishers at least control their own product. Content, as the old adage goes, really is king - and so investment in unique content that will either attract paying subscribers or advertisers means a publisher's destiny is much more in its own hands.

In Trinity Mirror's case, the priority has been to grow digital audiences with new tailored offerings; in the past two years it has launched a number of online only mags, such as UsVsTh3m and Ampp3d, which have helped it nearly double its online audience to over 60m monthly users in the last half year. To achieve this it has revamped its editorial structure to prioritise digital content production and also hired specialist digital staff from industry leaders such as MailOnline, the world's most successful news website. Local and national newsrooms have been integrated, ostensibly a cost-saving measure but one that also makes strategic sense - the launch of digital publication Scotland Now, for example, has been a huge success thanks to Scotland's independence debate with a far wider reach than local interest alone.

The result: digital publishing revenues rose by close to 50 per cent last half. More importantly, the company is extremely profitable and cash generative; it plans to reinstate its dividend this year, having taken a huge chunk out of its debt thanks to strong cash flows. And at 195p, the shares still trade at only six times broker Numis's forecast earnings. That suggests further upside lies ahead, and shows that you don't have to take a punt in the earliest stages of recovery to still make a decent profit.

Management matters

Having seen Mr Fox's struggle at HMV, some were sceptical at his appointment by Trinity Mirror in 2011 - there is an art to recovery situations, and the increasingly desperate tactics HMV tried to fend off the administrators suggested Mr Fox wasn't such a recovery specialist after all. However, his performance at Trinity Mirror suggests otherwise - which supports the view that a company in need of rescue needs bosses in charge who have been there before. A business operating in an industry in structural decline won't be turned around with a bit of financial trickery; in such cases, a fundamental rethink of the strategy is required (although turnarounds will always require a good finance man, too).

Most companies with high debt and squeezed cash flow will need to restructure their business - often no easy task given that such companies are also cash constrained. Management will often lay out a blueprint for recovery, which you should read carefully - the main question you should ask is: is this realistic? HMV's plan to turn itself around selling personal electronics made little sense, given that the category was suffering the same competitive dynamics as the business of selling music and video.

The second question would be: is it affordable? In most cases, the answer is no, and might demand a rights issue, which could prompt dilution concerns for the current shareholders. That said, any fundraising that is well-received or 'over-subscribed' means the company stands a chance of recovery. Although the short-term goal is wiping out debt, an 'over-subscribed' placing can deliver surplus funds, thus providing sufficient working capital for growth.

Directors involvement in rights issues and other forms of fundraising is worth watching out for as an insight into management's confidence in the future. And more general share purchases by executive directors are comforting, particularly if their stakes are large enough to give them an incentive to plough heart and soul into saving the company they're in charge of. Importantly, too, directors are insiders and have a better understanding of underlying trading - and, most importantly, the amount of cash coming into a business.

However, it's true that directors have caught onto this trend and often make 'token transactions' in the wake of bad news to feign false positivity - be wary, then, of directors buying small amounts of stock.

Selling the family silver

Instead of tapping shareholders for cash - and diluting their ownership in the process - companies may decide to save themselves through strategic disposals. A disposal, in particular, can be a good way for a debt-ridden company to strengthen its balance sheet in one fell swoop. Retailer Moss Bros (MOSB) is one example - it raised £16m from the disposal of its Hugo Boss franchised business in early 2011, which enabled it to plough funds into revamping its stores and more profitable own-brand ranges; the shares are up four-fold since then.

The risk, of course, is that a company may be forced to sell its best-performing divisions. Worse-performing parts of the business might not fund buyers and therefore not raise enough cash to make any meaningful improvement to the balance sheet, so 'distressed disposals' become the only alternative. Take Premier Foods (PFD), for example: building up a portfolio of food brands saw its debt hit £2bn by 2008, more than double the value of its equity. Selling off products such as Quorn and Branston's certainly helped keep the wolves from the door, but the remnants of the brand portfolio have proved a somewhat unsteady foundation from which to build a recovery. Its shares continue to languish at 43p, and a full-blown recovery still looks a distant prospect given its often fractious relationship with its major supermarket customers.

Major surgery

Sometimes a whole reshuffle is in order. This is not usually a luxury afforded to those companies that are in really dire straits, but for those that simply don't seem to be getting anywhere fast it's a good option. Pharma giants such as AstraZeneca (AZN) and GlaxoSmithKline (GSK) are both good examples. While neither is exactly at death's door, a lack of success in the lab and the inexorable rise of generic alternatives to their products mean both are suffering a slow demise. Shareholders, mindful that their capital could perhaps be put to better use elsewhere, have been growing impatient - one of the reasons Pfizer recently fancied snapping up Astra. For both companies, decline has become entrenched to some degree and any recovery is unlikely to be immediate.

Acquisitions are one way to slow or hopefully reverse this - both GSK and Astra have acquired smaller drug developers to give their drugs pipelines a shot in the arm, in the latter case in the valuable market for immunotherapy products, selling other parts of their businesses to fund the plan.

And therein lies the most important lesson of recovery investing: that it is a game for the patient and risk-tolerant only. Sure, big gains are on offer, but by diving headlong into a possible recovery without researching it fully can lead to you catching the proverbial falling knife. Recoveries can take time, and whether getting exposure to recovery through funds or individual shares you have to be prepared to be in for the long-haul and have your nerve tested many times along the way

The wider economic recovery has also made finding recovery value that much more difficult lately, even for some of the professional fund managers who employ a contrarian recovery strategy, often referred to as 'special situations' funds. We've listed some of these in the table on page xx, but before you invest in a recovery fund make sure you check to see how its investing - some funds may be touting themselves as recovery or special situations, but their core holdings look very much like any UK equity fund.

And that brings us onto the simplest recovery strategy of all - simply buy a market tracker in the period after a major correction, because research suggests these periods often bring above-average gains. Given the heady heights that markets are once again hitting, investors may wish to keep their powder dry for when the opportunity to profit from the market's bouncebackability presents itself once again.

Funds for recovery

Source: Trustnet & Winterflood

*Share price return

CASE STUDY 1: Apple's lessson in management brilliance

One of history’s biggest and best-known recoveries occurred at Apple (US: AAPL) when Steve Jobs, ousted in 1985 by the company he founded, retook the reins 12 years later. Few would have envied him the monumental task ahead. A Fortune article at the time read: "Apple Computer is back in crisis mode, scrambling lugubriously in slow motion to deal with imploding sales, a floundering technology strategy, and a haemorrhaging brand name."

A potent mix of passion, persistence and perfectionism enabled Mr Jobs to transform Apple from a waning power into the world's most valuable company. He slashed Apple's bloated product range by 70 per cent, embodying the 'hedgehog' concept of being the best at one thing, like a hedgehog that curls up to counter any threat. He also kept a discerning eye on every element of Apple's operations, from design and engineering to production, packaging, retail and customer service. That controlling mentality has manifested into today's ecosystem of Macbooks, iPhones, iTunes, the App store and Apple stores.

Mr Jobs' infamous negotiation skills allowed him to broker deals with the world's largest music and book publishing companies. And his focus was firmly on the future, attempting to predict what consumers would want before they knew themselves.

Focus, attention to detail, vision and deal-making skills are vital parts of any comeback. But Mr Jobs went a step further, moulding the revitalised Apple in his image. It's no wonder, then, that doubts remain over successor Tim Cook's ability to maintain the unique culture Mr Jobs inculcated.

Apple's team-up with IBM and its purchase of music specialist Beats show that Mr Cook isn't afraid to change or take risks. But the company continues to coast on the success of the iPhone and iPad. And its shares trade close to an all-time high, thanks to the hype surrounding the iWatch, iPhone 6 and other rumoured products. Apple's challenge is to retain its dominance in key markets and break into new ones, but that looks harder than ever given stiff competition from the likes of Samsung, Google and Microsoft. It seems that the greater a company's recovery, the further it has to fall. TM

CASE STUDY 2: Join Born-again Wincanton on its road trip to recovery

Wincanton (WIN) chief executive Eric Born says the group has done "a tremendous amount of work" and is two years into its recovery plan. This makes it a prime target for investors looking to cash in on a company whose turnaround is under way.

During the recession, Wincanton's shares plummeted more than 90 per cent, providing it with a rock-bottom base from which to come back. At the time, falling imports from the Far East and a slew of high-profile retail customers going bust were blamed. But it was also drowning in an immense debt pool and pension deficit, which prompted the cancellation of the dividend and the disposal of the mainland-Europe business.

But results for the year to March suggest progress is in motion. A close eye on costs drove underlying operating profit (which excludes pension deficit gains and amortisation) up 6 per cent to £48m and boosted the underlying margin from 4.2 to 4.4 per cent. Importantly, the freed-up cash pushed net debt down by 40 per cent. The pension deficit now stands at £111m (from £149m in 2013), with a £16m net gain after 1,100 employees moved to a defined contribution scheme last year.

So what helped Investors Chronicle's made identify Wincanton as its top value stock for 2014? First of all, fresh management signalled a fresh start. There was a clear strategy to concentrate only on the UK and Ireland, as well as make the debt and pension deficit top priorities. Crucially, there was a steady stream of new contracts, which would underpin future cash flow. This continued through to the year-end, with long-standing clients WH Smith and Marks & Spencer renewing their contracts. It's also worth noting Mr Born has a number of options in the company, which are proportional to its future success. HR

CASE STUDY 3: Punching below its weight?

Punch Taverns (PUB) is, in theory, a retail investor's worst nightmare. The group is collapsing under a spectacular debt pile - now in excess of £2bn. And a market capitalisation of approximately £65m and a languishing share price of 9.8p doesn't make it sound good on paper. But should it? After all, companies don't shut off the lights due to large amounts of debt. In fact, plenty of Punch's competitors find themselves with similar debt but are nonetheless attracting investors via cheap ratings.

Debt is no reason to write off a company in isolation. The question is how easily that company can get out from under that debt. It is this quandary that throws pub company Punch Taverns (PUB) into the spotlight. For Punch, the usual concerns of cash flow are no less important, but the complexity of the debt is the key concern here. Quarrelling bondholders, who own various tranches of the decade-old debt across two securitisations, have hindered Punch's board from making timely decisions for most of 2014. Now, management has been forced to accept a restructuring deal that will wipe 85 per cent of value from most shareholders' stakes - big and small. The saving grace is the deal will cut group debt by a quarter to £1.6bn. But still no agreement is settled. In the middle of August, Punch said a final agreement would not be met until October - just the latest delay in the saga that is Punch's potential future.

Is this agreement enough to keep a company like Punch afloat? Chairman Stephen Billingham says reinvestment in the core estate has continued while the board wrangled with creditors, implying he sees value in the estate post-restructuring. But investors tempted by Punch's recovery story have to consider the future - and the wider pub industry trends. The industry is dealing with significant changes in consumer behaviour, many of which require heavy investment in pub upgrades and refurbishments. Plenty of Punch's competitors have returned to acquisition-led growth strategies made popular pre-recession, but doubts remain over Punch's ability to emulate this approach. Any free cash will go towards further debt repayments, even post-restructuring, which won't leave much left for estate upgrades or shareholder returns.

Enterprise Inns (ENI), which brought itself back from the brink (and similar amounts of debt) in 2012, should not be seen as a precedent but merely as an exceptionally successful recovery story. HR

CASE STUDY 4: Rebuilding the housebuilders

Hindsight is a wonderful thing, but applying anything more than a trickle runs the risk of being smug. So it is with housebuilders. When the crash came, shares in housebuilders collapsed. Most had to turn to shareholders to raise fresh finance in order to pay down debt. The problem was that devaluing the value of the land bank as prices fell through the floor left most builders in breach or in danger of breaching their banking covenants. Banks at the time were already drowning in bad debt and were anxious to avoid calling in loans that couldn't be paid. No one wanted to buy a house at the time (hoping for further price falls). So what prompted many brave souls to buy shares in housebuilders?

There were a number of key reasons that supported what seemed at the time an exercise in throwing good money after bad. The housebuilding sector is and always will be a cyclical beast; so buying shares somewhere near the bottom of the downturn makes sense, even if you don't get the timing quite right. In fact, if you had bought shares in housebuilders in any January in the following five years from 2008 you would have made a tidy return. Secondly, housebuilding may have collapsed at the time, but the demand for housing did not. Those taking a long-term view found support in the fact that at some point output would have to start playing catch-up with demand. The third factor often overlooked was that as housebuilders shed staff and gave up buying any land, their cash flows improved significantly. Net cash flow for the top seven housebuilders was forecast at £178m for 2008, but estimates for the following year exploded to £1.29bn.

Sure, profits fell sharply, but some of this was a paper loss, as land values on the book had to be written down. And if the risk-reward ratio at the bottom of the cycle was just too much to allow investors to sleep at night, the most obvious buy signal came when nearly all the housebuilders went cap in hand to their shareholders for more money, and shareholders stumped up the money.

Some canny investors took the view that the downturn - overdone or not - simply provided an opportunity to invest in the recovery that had to come. By the middle of 2008, the bounce had already started. Shares in Telford Homes (TEF) rose by 14 per cent in one month, while shares in Barratt Developments (BDEV), having collapsed 90 per cent in the previous 12 months galloped back 65 per cent. These percentage changes were a little academic because at the time the shares in Barratt were only worth 25p, although the brave investors who bought then are currently sitting on a 1,300 per cent gain.

When times were really bad, it was hard to put a value on housebuilders because few people had the nerve to call the bottom of the cycle. However, even though the downside looked like a hole with no bottom, a reality check at the darkest point would have shown that, on average, the major housebuilders were trading at a discount to net asset value of 54 per cent, with Barratt Developments sporting a 75 per cent discount. The point here is that valuations could have taken an even bigger knock and still left the shares at a discount.

So, how did all the large housebuilders come back from the brink? Most of the answer comes from the fact that big builders suddenly became small builders, and small builders, by and large, ceased to exist. Cutting back production, reducing headcount, slashing the dividend, and no more land buying were the primary medicines that stopped the rot. Two builders were taken private - Crest Nicholson and McCarthy & Stone - while the rest were obliged to limp along, subsidising a ravaged private sector by building more low-margin social housing. But none of them went bust.

But the catalyst that underwrote the recovery came when Bank rate was cut to 0.5 per cent. It took a while for potential housebuyers to catch on. After all, rising unemployment was one of the biggest influences on whether to jump onto the bottom rung of the housing ladder. But the building blocks were in place and it only took an improvement in mortgage availability to set the scene for a sustained recovery, which still has some way to run.