Anthony Bolton: My favourite type of share

At the heart of my approach, particularly in the Fidelity Special Situations fund, has been buying recovery or turnaround stocks on attractive valuations. These are normally businesses that have been doing poorly, perhaps for some time.

Many investors, in my experience, don’t like to be associated with businesses that are not doing well and can miss when a change for the better occurs. This often involves changes in the management team, a restructuring or even a refinancing (or a combination of these).

A great sign often comes when analysts give up on a company and there are few people making forecasts on the business. Another opportunity can arise in companies coming out of bankruptcy. I’ve done well with these types of company – such as the cable TV companies, Marconi and Eurotunnel. They tend to be completely off most institutional investors’ radar screens. In a similar vein are companies with complex or unusual capital structures, which put off many investors.

The best recovery stocks in my experience are those where new management comes in who can demonstrate that the company in question lags behind its peers on a number of fronts and they have a clear plan – which normally involves doing lots of little things better – to return it to performing in line with, or better than, its competitors. Retailing, where it’s often said “retail is detail”, is a good source of these types of recovery situations.

Often, you need to buy a recovery stock before you have all the information and the purchase doesn’t feel comfortable – don’t be put off by this. By the time all the information is there and the recovery is established, an investor will have missed some of the most rewarding times to own the shares. Sometimes investors must force themselves into this “discomfort” zone.

However, on the downside, it’s very easy to be too early in recovery stocks and this is the mistake many investors make. I will sometimes take a very small holding at this stage (say, 10 basis points) which helps me focus on the stock and then add as my conviction grows that the worst is over.

It is an important observation that the first bad news (such as the first profit warning) is rarely the last.

A warning sign of more bad news to come can be what are called “brave face” trading statements from managements. They tend to be general and bland and not very specific about the future. So a recovery buyer must be patient, especially in timing his main entry point.

A particular situation that occasionally occurs is one where the shares of a company decline for some time in anticipation of an event that is well known and perceived to be bad (such as big lawsuit or an entrant into their market). Often, by the time the event arrives, it is well in the price and buying just beforehand makes sense.

Other companies I like are those with asymmetric pay-offs – stocks where you might make a lot of money but you can be confident you won’t lose a lot.

An example of this would be an attractively valued oil exploration company with sustainable cash flow from existing wells – and a strong balance sheet that reinvests this cash flow in exploration, including some wildcat wells where reward can be very high if successful. A company like Cairn Energy has done this very successfully, twice discovering “company-maker” fields.

I am less keen on symmetric stocks, unless the odds are really attractive.

As well as recovery stocks, I like companies selling at a big discount to their assets, unappreciated growth stocks (maybe in areas unfamiliar to many investors or maybe having a growth division that is hidden within a company whose main business is less attractive), valuation anomalies in a particular sector (say, the cheapest stocks in a sector that I don’t think should be the cheapest) and takeover targets. Of course, these criteria are not mutually exclusive.

Jeremy Grantham, chairman of GMO, makes some very interesting observations about growth and value investing in the US: “Growth companies seem impressive as well as exciting. They seem so reasonable to own that they carry little career risk. Accordingly, they have underperformed for the last 50 years by about 1.5 per cent a year. Value stocks, in contrast, belong to boring, struggling or sub-average firms. Their continued poor performance seems, with hindsight, to have been predictable and, therefore, when it happens, it carries serious career risk. To compensate for this risk and lower fundamental quality, value stocks have outperformed by 1.5 per cent a year.” I couldn’t put it better. I know where I want to place my bets given these long-term odds.

Extracted from Investing Against the Tide by Anthony Bolton. To be published by FT Prentice Hall on April 2, 2009, price £14.99. ISBN: 9780273723769. Order with a 20 per cent discount at www.pearson-books.com/ anthonybolton

© Anthony Bolton 2009