Ready for a turnaround

The message of all these lists is that success is defined by a comparatively transitory range of share price movements – prices go up and down, they move with markets, a merger or acquisition deal occurs and everyone gets excited and starts a brief bidding war. They don't always start from the correct premise, either: all too often, lists are compiled solely on the basis that the shares are cheap relative to their long-term averages. This isn’t necessarily the same thing as a company poised for a price recovery on its own merits. 

Unfortunately, there is no guarantee that something bought cheaply will eventually become profitable, or that any so-called big theme will eventually approximate into higher shareholder returns. So what does 'recovery' actually mean, and constitute, in the context of share picking? What theoretical framework can investors use to help distinguish between a share on the up and a value trap, and what catalysts should they be looking for?

To appreciate the mechanics of how share prices recover, and to stand a chance of succeeding in practice, investors first need a solid understanding of the theory.  

The recovery shares toolbox

The traditional, if unfashionable approach to finding a recovery share requires an analytical toolbox to help identify the corporate actions that really make a long-term difference to how a company performs. A lot of the theory on how corporate actions affect the performance of shares can be traced back to Maurece Schiller’s seminal book Special Situations in Stocks and Bonds, first published in 1955.

The work encapsulates Schiller’s experience of the Great Depression, which sent him in a radically different direction from near-contemporaries such as Benjamin Graham. The Depression not only unleashed misery on millions of jobless Americans, but also caused unprecedented levels of corporate activity as managements scrambled to cut costs, consolidate and rebuild their businesses. The economic stimulus of the Second World War and the resulting boom inspired Schiller to propose a system for investors to take advantage of special situations – a phrase that represents the true definition of a recovery share.  

Schiller’s most controversial idea is that investors should buy into a situation with a clear idea of how much profit is likely to accrue. That suggests that recovery situations are only worth undertaking if investors can make an accurate estimate of the likely return. Whereas one common rule of investing is usually framed as “run your profits, but always cut your losses”, Schiller poses the question: “How much profit is worth the effort?”   

To find an answer to that challenge, there are five key questions to ask before betting on a recovery:

1. Is the calculated profit limited by the type of situation, or is more available?
2. Does the situation have more than one possible corporate action?
3. Is the profit established only at the end of the action?
4. Will profits accumulate progressively?
5. Would a long recovery situation enhance or consume the expected profit?

With the framework to the investment thinking established, the easiest way to relate Schiller’s thesis to reality is to acknowledge that recovery shares emerge due to conscious decision-making and active corporate actions. The change in market sentiment – and the profit – comes later.  To capitalise fully on these events, an investor must be prepared to wait. But they should also know what they are looking for, and what they are not.

Avoiding value traps

A value trap is in many ways the opposite of a recovery share. One definition of the former is a company that might be perfectly profitable, but which shows few signs of serious or sustained earnings growth. Often, there is a comparatively high dividend yield on offer. Typically, however, there are few possible corporate actions available to the company that aren’t in some way constrained by legal or regulatory frameworks.

The telecoms companies, and their years of relative underperformance, are a good example. After booming at the start of the millennium due to the widespread adoption of mobile phones, the industry rapidly outgrew its earning potential as its core offering became commoditised and ultimately superseded by changing communications technologies, and it consistently had to pay over the odds in government-sponsored spectrum sales. The net result is companies that tend to pay high dividends, but whose shares stick at historically low ratings. While the involvement of activist investors at both BT (BT.A) and Vodafone (VOD) has turned some heads this year ('BT and Vodafone expected to speed up consolidation under activist pressure', IC 11 February 2022), both companies require major restructuring before they can return to minimum levels of growth.  

This kind of overhaul takes time, but there are actions to which investors should be alert if they want to spot a possible recovery situation.

Five corporate actions that can trigger recovery

1) Change the management

Chief executives can expect to last slightly longer in post than a football manager – according to Sky Sports, the average footballing incumbent will be in the job for 477 days, which might be considered generous in some cases. The head of a FTSE 100 company can expect a minimum of four years in-post before it is someone else’s turn. Tracking the changes in personnel is often a fascinating study in personalities that define an individual’s approach to business. The basic test for investors is whether a chief executive leaves a company in much better shape than he or she found it.

Two of the recovery situations we highlight below have a common link: Leo Quinn. Quinn headed banknote printer De La Rue (DLAR) between 2004 and 2008, before a move to defence research company QinetiQ (QQ.) for a half-decade spell starting in 2009, then took on the ultimate poison chalice at a flailing Balfour Beatty (BBY), currently the subject of fines in the US over contracts for military housing. 

Quinn has a good reputation in the market – the announcement of his roles at QinetiQ and Balfour triggered 15 per cent share price jumps on each occasion. That's because he tends to favour the sort of large-scale corporate actions that give special situations investors a chance at achieving a profit over the years ahead.

QinetiQ is the perfect example. What was the Defence Evaluation and Research Centre became QinetiQ after a spectacularly botched sell-off by the Ministry of Defence to US private equity firm Carlyle Group. When the previous management decided to cash out when QinetiQ was listed in 2006, making millions in the process on paltry personal investments, Quinn was brought in to sort out the mess. He first act was a wholesale reorganisation of the company that included cancelling all previous collective bargaining agreements, which included some exceptionally generous severance terms for its ex-civil service staff.

QinetiQ’s management had been trying to restructure the company prior to the management change, but the cost of downsizing had become financially ruinous. The civil service contracts inherited by the privatised company meant that QinetiQ had to pay out as much as two years' salary to make individual employees redundant. It is fair to say that Quinn did not make himself popular by radically cutting those terms, but the market loved it.

His five years in charge yielded a relatively modest gain of around 30 per cent for shareholders who stuck around for his full tenure. But it is worth noting that QinetiQ’s share price peaked at the mid-point last year at 357p, suggesting that he at least built some decent foundations for his successors. The company really was a mess in the late 2000s; overall, it was a decent recovery effort that yielded a good profit for long-term shareholders.

It is possible to point to incremental success for Quinn at Balfour Beatty, despite the negative headlines coming out of the US. The company is after all a prime contractor to the Ministry of Defence in the UK, although it must still shed the construction industry’s perennially bad habit of overbidding for work and then underdelivering. Shareholders who bought the company’s shares the day after the announcement of his appointment in late 2014 are now sitting on a 50 per cent profit, although the share price was up more than 100 per cent between late 2014 and last summer's news breaking of the scandal in the US. In any case, a closer look at the balance sheet over that time reveals some notable progress.

As the heavily summarised table indicates, you might fault the execution at times, but not the chief executive’s financial husbandry. Most interesting is how Quinn has clearly built up the company’s capacity for expansion by managing down long-term debt over his tenure and increasing the amount of retained earnings. If Balfour’s intention is to expand further in the US through acquisitions, then spending and slowly introducing more long-term leverage will be critical. Whether the chief executive will continue after seven years in the post, having nursed the company through this process, or whether shareholders will opt for a more aggressive style, is a moot point in the context of the work already done.

2) Spend your way to success: The case of AstraZeneca

Any investor brave enough to buy AstraZeneca’s (AZN) shares in 2009 at 850p is now sitting on a handy 950 per cent, and rising, profit. While the company’s success seems so obvious now, AstraZeneca was not the toast of pharma investors at the start of the new millennium. In fact, there were real questions over whether it would survive in the long term and many investors looked to GlaxoSmithKline’s (GSK) oddly diversified business model, with low margin but stable revenues from consumer products, as the likeliest beneficiary of future trends in the industry. It is not hard to understand why there was such scepticism. Astra was suffering severe patent attrition and the management at the time – doing its best impersonation of lotus-eaters - seemed to have few answers other than to sit back and keep paying out generous dividends from rapidly shrinking profits.

A change was inevitable and the appointment of Pascal Soriot, formerly a divisional head for Swiss pharma giant Hoffman-La Roche, was the catalyst for recovery. However, the significant corporate action in this case was the realisation that Astra had the balance sheet and the resources to spend big on new pharmaceutical products, in particular the high value, difficult-to-copy area of cancer drugs.

Under Soriot, AstraZeneca’s specialisation became oncology, and a pipeline that seemed thin and uninspiring a decade ago now contains more than 170 products in development. The company now spends roughly 23 per cent of sales on its research & development and, while throwing money at projects is no guarantee of ultimate success in pharma, the returns can be excellent when the expertise is in place and a distinct vision is pursued. For that reason, AstraZeneca is probably one of the rare recovery buys that is worth holding well after the recovery phase is over.

3) Dispose to transpose: Tate & Lyle and GSK

It is not often that a company getting rid of its core product can produce a resurgence in the share price. Investors with longer memories will shudder at the thought of former widows and orphans share GEC betting everything on the dot.com boom by selling its defence business and winding up as a footnote in “How not to…” books of management. But there are some successes to go with these failures, and Tate & Lyle (TATE) has drawn a lot of attention this year for the rising margins in its business and a willingness to dispose of underperforming divisions.

Anyone with particularly rose-tinted memories of childhood will remember the thrill of golden syrup poured on hot toast. The decision to offload such an iconic part of its business raised eyebrows in 2010, but the reinvestment of the £211m proceeds into the higher-margin food and beverage arm has been a boon for the company’s share price. Tate also recently sold its sweeteners business in the US for $1.3bn (£950mn), underlining the point that there is sometimes more value in owning less. Overall, the strategy makes sense: the reputational problems of selling a product that contributes to increasing problems associated with obesity and diabetes in the developed world are solved instantly, and it is free to concentrate on building its more profitable businesses. Any pullback in the price is a chance to get on board.

Contemporary spin-offs offer their own potential. It will be interesting to see how GlaxoSmithKline performs when the divestment of its consumer arm is completed in the second quarter, having rejected a series of offers from Unilever (ULVR) for the business. The reassuring point for investors is that things can only get better from this point if the management is serious about investing in the pharmaceutical product pipeline. Having seriously neglected the pharma side since the merger with SmithKlineBeecham, the new GSK has a chance to build on the expertise in its vaccines business and HIV franchise. One possibility is that a newly leveraged consumer products company (which will be 80 per cent controlled by GSK shareholders) will support the cash investment that GSK’s pharma division needs. A capital markets day scheduled for 28 February should give investors more clarity on the strategy for both businesses.

4) Corporate buybacks: Roche reworks its ownership

Whereas spin-offs and management changes are very visible alterations, capital and ownership reorganisations are often overlooked as signals for a recovery in the share price. Yet they can provide companies with much greater flexibility when it comes to raising finance and broadening their capital base, setting the scene for bigger plans in the future. An example of some serious spring cleaning came late last year after Swiss company Roche (CH:ROG) and Novartis (CH:NOVN) – or the sisters of Basle, as they are also known – agreed an enormous $20.7bn stake buyback whereby Roche repurchased the entirety of Novartis’ 33 per cent stake in its business. Novartis shareholders were immediately rewarded with a $15bn share buyback.

The deal helped to reorganise Roche’s ownership base, as well as removing the suggestion that both companies had an overly close relationship. While a recovery for Roche, which has been facing patent erosion pressures over the past two years, is helped by its highly profitable medical diagnostics and devices business, it is the state of Novartis that should interest the market more. The reason is that the company has considerable scope for corporate actions and one of these is the future of its generics business. The fact that a big pharma company also owns a generic is a quirk of the German and Swiss system, where 'branded' generics hold considerable market share. Novartis is reviewing the future of its Sandoz generics business and there is a possibility that it will be sold, in which case investors will start to wonder what the management intends to do with a balance sheet that is already groaning with cash.  

5) Expand or die? London Stock Exchange bets big on data

It is possible to get the strategy correct, only to then mess up the execution. That is particularly the case when it comes to M&A, and this fear has stalked London Stock Exchange (LSEG) following its $27bn deal to buy Thomson Reuters' data business Refinitiv. The deal seemed the perfect solution to the LSE’s long-term concerns over its viability as a pure market maker and equities “plumber” – facilitating the trades that make the market work.

Data has been a growing business in recent years as financial firms started to understand the value of the data they generate in their day-to-day activities. So the LSE’s move made sense from a strategic perspective, as Refinitiv provides the analysis and raw data on which banks, financial firms and investors all rely. The problem has been the price it paid for the deal, plus the far higher than expected costs of capital investment – the LSE won't see much change from £1bn in necessary capital spending; one of the reasons that Refinitiv’s management pushed for the merger was frustration at longstanding underinvestment. The market has so far not forgiven the apparent lack of due diligence when it came to assessing Refinitiv's capital needs and the share has been a notable fall ever since the spending plans were disclosed. 

A lasting recovery in the LSE’s share price now depends on its management being able to turn around Refinitiv and ensure that the capital investment costs do not exceed what has already been advertised. The corporate action to watch for at this point might be a possible change in management, as both LSE's chairman and chief executive have little experience of executing such a large turnaround proposition. An investment in the shares at current levels is in effect a position on how smooth that process ultimately proves to be, ahead of a recovery taking hold. Investors will have a chance to see what progress is being made when full-year results for 2021 are published on 3 March. 

The beauty of buying into recovery shares following analysis of corporate actions is that the debate over market timing is entirely redundant. In effect, the timing is taken care of for you. However, as Maurece Schiller also made clear, the strategy requires aggression and a sure grasp of underlying research. If the positions are too small, an investor won't achieve enough market alpha to beat a simple basket of tracker funds. In other words, go big, go bold. That specific insight probably owes a debt to value investing theory, but it is often the case that the best investment strategies are the sum of accumulated wisdom.