Understanding special situations

With market uncertainty depressing many companies’ valuations, a growing number of stocks are finding themselves out of favour. We sift through these unloved businesses and look for what are known in investment parlance as special situations.

Some investors may think this is a euphemism for businesses that are in dire straits. For us, by stark contrast, the phrase is in many ways a synonym for opportunity.

This is because special situations – or “special sits”, to use the vernacular – are frequently characterised by a disparity between short-term difficulties and longer-term prospects. The special situations we invest in are businesses on depressed valuations where improvement is being internally generated by management actions and where good execution can produce outsized shareholder returns. While circumstances may have left them unloved, these “ugly duckling” stocks retain a capacity to turn things around and deliver strong results.

Most investors do not appreciate this capacity. The herd perceives weakness and directs its attention elsewhere. This means special situations investors must exhibit a contrarian streak.

So how might we distinguish genuine special situations from flat-out basket cases? And how might this asset class contribute to a broader portfolio, particularly amid the challenges of the current economic climate?

Finding positives and potential

Depressed valuations tend to stem from a negative event. It could be one that is specific to a business, such as a misjudged acquisition, or one that is all-encompassing, such as the pandemic. But a negative event can also provoke a positive reaction – most often in the form of new management.

This, arguably above all, is what investors should look for in a special situation. They need to determine whether newly appointed executives are capable of identifying where a company has gone wrong and implementing the right measures to get it back on track.

As the managers of a special sits fund, how do we assess if this is the case? First and foremost, it is essential to meet the new leaders. We are most likely to invest if management can articulate a business’s strengths and weaknesses and lay out a compelling strategic vision for the way ahead.

We take into account considerations such as the recovered earnings and cashflow potential, risk/return profile and, crucially, valuation. This requires us to dig deep, see past the noise and truly understand a company’s share-price upside. We must have confidence before we initiate a position.

Ultimately, it is a question of engagement and research. These are the foundations of special sits investment decisions, and they are entirely at odds with the herd’s knee-jerk abandonment of a seemingly troubled stock.

The turnaround process

Special situations funds are sometimes referred to as recovery funds. This designation may be largely apt, but it can confuse economic recovery with business recovery.

For business recovery it is rehabilitation that comes first. Management needs to garner enough support from investors to set in motion a series of plans to right the ship. A successful journey is likely to involve numerous milestones, including reducing debt with a capital raise, cutting costs, disposing of unprofitable or non-core divisions and improving policies and practices.

This sets up the recovery phase, which is marked by margin expansion and revenue growth. Ideally, a business will eventually experience revitalisation and show accelerated growth and operational gearing.

It is possible to invest during any or all of these phases. Our experience is that it makes sense to tread lightly during the riskier rehabilitation stage and then add to our holdings as evidence of a recovery mounts. We will regularly revisit with management to check progress against the plan.

Naturally, as with any investment, it is necessary to accept some things cannot be controlled. For example, as special sits fund managers, we do not try to time the market – we are of the view that business recovery can be more powerful than the economic cycle.

Contrarianism as a natural diversifier

However, just as they cannot avoid it, investors also cannot ignore the influence of macroeconomic conditions. The era of easy money is over, and the quest for portfolio performance is now significantly tougher than it has been for nigh on a decade and a half.

As a result, many investors are acknowledging the need to cast their nets more widely. They are diversifying away from the established strategies that consistently served them well in the past but which are no longer so agreeably reliable.

Special situations funds can deliver diversification across sectors and industries and across the market-capitalisation spectrum. The constituents of the Artemis UK Special Situations Fund include pharmaceutical giants, financial services providers, luxury brand retailers, transport firms, telecommunications businesses and leisure companies. We have large-cap, mid-cap and small-cap holdings.

Importantly, due to the contrarian nature of the process, special sits investments are likely to diversify a portfolio away from the growth concentration built up over prior years. This could be a notably attractive attribute at a time when interest-rate moves are changing the market’s valuation dynamics.

Of course, special situations may not be for everyone. Going against the herd demands a daunting combination of courage, commitment, hard work and expertise. But we believe the merits of such an approach are likely to become increasingly apparent as investors search for new sources of returns in an unfamiliar, disruptive and occasionally hostile economic landscape.