VALUE INVESTING
Winning With Recovery Investing

By Stephen Bland (TMFPyad)
September 10, 2004

One type of value share that can prove to be a winner may occur where a reorganisation has taken place following a period of poor, even disastrous, trading by a company. In such cases the historical accounts figures may tell you very little about the current fundamentals or present state of the business and you have to rely more than usually on forecasts, news, directorspeak and so on.

In these situations you may be placing more faith than normal upon the skills of the management carrying out the reorganisation but provided the price is right this can be a good play. However, I don't like relying on people more than you have to because they have the unfortunate habit of letting you down too often. Consequently, you need to look closely at Price/Tangible Book and Net Cash with these shares because that is where your downside protection is most likely to arise.

Historical P/E and yield may mean little if the business is not altogether the same one going into the future as it was in the past. It is quite likely that during the transition very low profits or losses may be generated as the company dumps underperforming assets and has to pay the extraordinary costs associated with redundancies and closures etc. Thus the low P/E filter associated with value may not locate such shares during the usual screening process. Similarly dividends may be cut or suspended during the reorganisation so that the value filter of high yield will not catch such a share.

I would expect though that recovery shares are trapped in a low P/TBV and Net Cash filter. Often, for a while, recovery shares may trade below book until it is proven that the new management can turn the business round. Also, it is quite common for cash to be generated during the reorganisation process, not so much from trading but from selling off unwanted and underperforming assets. Selling off unwanted parts of a business is the friend of value, the opposite to acquisition being its enemy.

It is down to human skills as to how much profit can be wrung out of a given set of assets. skills that, as I say, may not be too reliable. But the actual existence of assets and cash in the company is more of a physical fact that exists almost outside of human interference. I know that the management can mess the assets up too, but it is far harder to do that than it is to simply mismanage assets so that poor profits or losses are generated from them.

In consequence, trading below book and net cash offers strong protection should the reorganisation not go as expected. Remember that minimising the downside is the first rule of value investing, not looking for upside. I seek these two features of below book and net cash in normal value situations too as regular readers will know but they become especially important in recovery shares where the P and Y in pyad, P/E and Yield, may not figure too strongly.

To try and locate potential recovery plays, filter on P/TBV well under 1 ignoring shares that habitually trade that way such as properties and investment trusts,  then examine the list thrown up. Don't worry about P/E or yield at this stage. Study the latest news and accounts, press reports and directorspeak, looking for clues as to new management, talk of selling off underperforming assets and so on. You are looking for net cash with mention of recovery about to get underway, or perhaps already well established but not yet recognised in the share price.

What are the risks with recovery plays? The most obvious one is that the new management's efforts may go awry. In that case you have the downside protection of the asset and cash position assuming they don't blow that too. If the share is a very small cap, you have the added risks of all small caps generally of big spreads, possible difficulties in trading large amounts of the shares and so on.

Many of my successful value plays in the past have resulted from recovery situations. Not all of them had nil yields either. Earning a decent dividend whilst waiting to do the business only adds to the attractions of recovery shares.

In my Value Investor newsletter, in our regular searches to locate suitable selections we automatically cover potential recovery shares that have the appropriate value features I show above. You can sign up here for 30-day trial, which allows you to review all eight issues we've published so far this year.