Ride the market rotation with M&G Recovery

The fund is in the top quartile of the Investment Association UK All Companies sector in terms of performance over one year, ranking fifth out of 263 funds. It returned 38.1 per cent, beating its benchmark, the FTSE All-Share index, which returned 26.4 per cent over the same period. But over three and five years it underperformed the index and the IA UK All Companies sector average.

There has been strong investor appetite for companies with dependable earnings - expensive defensives - which have done well since the global financial crisis. But with inflation picking up, interest rates rising in the US and investors turning towards more growth-orientated companies, M&G Recovery's holdings could benefit.

"According to [M&G Recovery's manager], material operational progress for many of his portfolio holdings was widely ignored by the market until the mood changed last year," says Rob Morgan, investment analyst at Charles Stanley Direct. "To him, the change in direction of bond yields that occurred at around the same time is no coincidence. Investors began to rethink their expectations of low growth and inflation, adopting a different approach to risk, which resulted in a more conducive environment for the fund. Not only were investors more inclined to consider economically sensitive areas where the fund has significant exposure, but appetite for merger and acquisition (M&A) activity increased, shining the spotlight on some of the unrealised potential in the portfolio."

For example, one of the fund's holdings, Lavendon (LVD), has recently been the subject of a bidding war by overseas buyers, and its share price more than doubled in the space of two months. Other companies in the fund's portfolio may also be subject to M&A activity.

M&G Recovery also benefits from an experienced, well-resourced management team. Tom Dobell, who has run the fund since March 2000, is supported by equity analysts, and credit and corporate finance teams.

The fund aims for capital growth by investing at least 80 per cent of its portfolio in UK-listed companies that are out of favour. The manager takes a long-term view, typically holding stocks for five years or more.

Mr Dobell focuses on three key factors when assessing a company: its people, strategy and cash flow, often building relationships with managements to gain an in-depth understanding of companies. He cites a three-stage process where companies go from 'unloved' to 'stabilising' to 'recovering well', and aims to invest at the initial stage through to recovery, when he will sell. The portfolio includes businesses of all sizes, and has more than a third of its assets in medium- and small-cap stocks, including Alternative Investment Market (Aim) shares.

The fund's contrarian style of investing in out-of-favour companies can lead to sustained underperformance as evidenced by its poor returns over three and five years. And there is no guarantee that the past year's strong performance will continue.

But Mr Morgan says: "Companies that have been shunned by the market may have serious challenges that cannot be resolved. It is not unusual for things to go wrong, for a company to never recover or, even worse, to go bust, losing investors all of their investment. Yet by having great patience, more winners than losers, and, if necessary, providing help in the form of third-party expertise and finance, M&G Recovery has enjoyed some fine periods of performance."

So if you're willing to invest for the long term and believe Mr Dobell can continue his return to form, then M&G Recovery's contrarian holdings could be a way to capture strong performance in the changing market environment. Buy. EA.

Source: Morningstar as at 06/02/17, *M&G Investments as at 31/12/16

Performance

Source: Morningstar as at 03/02/17

Top 10 holdings as at 31/12/16 (%)

Source: M&G Investments

Sector breakdown, as at 31/12/16 (%)

Source: M&G Investments

IC Tip Rating