The turning point: When we’re on to a winner

One of the most promising moments for a special situations manager is when other market participants, whether they be brokers, analysts or other fund managers, independently start to echo your investment thesis.

After you have built a position in an out-of-favour stock, then watched its turnaround story translate into accelerating earnings growth, there is often a sudden change in sentiment and a jump in the share price as other investors come round to your way of thinking.

Investor sentiment is just as important as financial delivery. Earnings underpin share prices; narrative drives them forward.

Any investor would like to be holding a stock when it gets to this point, so how can you anticipate when it is about to happen? Well, in the same fashion as Ernest Hemingway’s quip about bankruptcy, “Two ways. Gradually and then suddenly.” This is how we try to get there.

Meet the management teams

It starts with a blank piece of paper. Meeting with companies that have fallen out of favour, of the type that most investors dismiss out of hand. In many cases, we end up doing the same – but only after we have taken the time to sit down with management teams and listen to their recovery plans.

Experience is vital here, as it helps you to spot patterns and similarities with other businesses that have managed to turn themselves around in the past.

If you like what you hear, then dig further and make your own judgment on whether the management team is likely to succeed. Or to put it another way, separate those that are capable of spinning a good story from those that are capable of delivering on it.

Of great importance at this moment is the balance sheet. You may be dealing with a great management team, but if they don’t have the time to turn the business around before it runs out of cash, they aren’t much use to you.

Start small and be patient

Then, once you’ve carried out your own research and are convinced that the turnaround plan and balance sheet are solid… you buy small and you wait.

Some people muddle special situations investing with value investing. Value investing heavily relies on screening. You are playing the odds, which quantitative studies would suggest are stacked in your favour, but you are relying heavily on historic financial information. This means you are normally just buying struggling businesses without a forward-looking filter and hoping for the share price to bounce back.

Before we invest meaningfully, we need to see operating momentum, some progress to compare the management strategy against. This acts as a catalyst for further investment, when the first piece of the puzzle falls into place and tells us a stock is off the slippery slope and on the road to recovery.

This could be the disposal of unprofitable assets, the successful delivery of a restructuring programme, a key acquisition or signs of revenue acceleration.

It doesn’t even have to be positive news – for example, a series of write-offs at Babcock showed us the new management team had grasped the full scale of its problems and were willing to take the difficult decisions needed to fix them.

Avoid herd mentality

There is limited upside to standing out from the crowd as a sell-side research analyst. However, there are great long-term rewards as an investor by staying away from the warmth of the herd. During dislocation events within markets, such as Brexit, Covid or the current Trump tariff situation, the downside scenario, whilst compelling, is less useful than the realistic one.

You could see this with the banks following the Liz Truss debacle. While the spike in interest rates was inevitably going to boost their net interest margins (and therefore profits) analysts arrived at a lukewarm outlook by predicting a large rise in loan impairments. When evidence started to emerge that these impairments were too bearish, they were only reversed slowly.

We think there could currently be a similar story for housebuilders, which are out of favour due to concerns about mortgage affordability. With higher wage growth and falling inflation, accelerated by the Trump-induced decline in the oil price and rise in sterling, mortgage affordability could be about to sharply move in the right direction. Interest rate cuts are firmly on the agenda for the Bank of England. If things turn out even slightly better than is being forecast, this sector could see a speedy acceleration in earnings growth due to its operational gearing.

Identifying a future recovery

The long answer to the questions “what is the turning point?” and “how do we know we are on to a winner?” is that there is no single moment, but rather a series of incremental data points that, over time, give us more confidence in a future recovery, building into a change of narrative that justifies a higher valuation multiple.

The short answer is when people who previously thought we were foolish start agreeing with us.

Or, as Hemingway summed it up: “Gradually and then suddenly.”