12 Oct 2023
Investors often assume that ‘special situations’ refers to companies in turmoil that represent high risk, but this is not so. The Artemis UK Special Situations team explain how using the 3 R’s – rehabilitation, recovery and revitalisation – can highlight why their capacity to improve makes these companies ‘special’.
The basic skills taught in schools were once commonly known as “the three Rs”. For this framing to work, it was necessary to refer to “reading, ’riting and ’rithmetic” – a phrase that perhaps takes too many liberties to qualify as a firm foundation for learning.
Three Rs can also be used to educate investors about the sphere of special situations, and in this instance there are no troublesome truncations or apostrophes in sight. With agreeable neatness, we can refer to “rehabilitation, recovery and revitalisation”.
These elements go a long way towards defining what investing in special situations entails. Investors often assume “special sits” vehicles are full of basket-case companies in areas of high investment risk, but this is not so.
For example, in the Artemis UK Special Situations Fund we hold jet engine component manufacturers, global luxury brand retailers, pharmaceutical giants and leading manufacturers of precision instruments. These are often companies with outstanding histories which, for a variety of reasons, find themselves out of favour – and whose valuations have fallen accordingly.
Crucially, they can now be seen as sources of opportunity. And this is really the point: despite the indifference of the herd, what makes these businesses “special” is their capacity to improve.
Fulfilling unrecognised potential
There are many circumstances that might give rise to a special situation. They usually affect a company’s short-term prospects while blinding the majority of investors to its longer-term opportunity.
Negative trigger events might include poorly timed acquisitions, overly ambitious growth targets or external shocks like the pandemic. But there is often a reaction: the appointment of a new management team that can enhance a company’s earnings potential.
Typically, if a business’s balance sheet is strong enough and there is sufficient valuation support, this is a good time for alert investors to start a shareholding. With new management in place, the process of rehabilitation can begin.
This is where much of the “heavy lifting” takes place. Management must diagnose and address the issues that have undermined a company’s standing. The market should be enthused by the effective articulation and execution of a plan to improve cashflow and margins.
Around half the businesses in our portfolio are in the recovery stage. We tend to increase our holding as a turnaround gains momentum and the new strategy begins to bear fruit.
Over time, ideally, better margins will enable more investment in areas such as R&D, marketing and sales. In turn, this should lead to superior revenue growth. As it becomes healthier, a business can keep pushing harder.
This virtuous circle marks the last of the three Rs: revitalisation. Having overcome its challenges, a company bounces back from its depressed valuation as growth accelerates – and an opportunity that most investors failed to acknowledge is fully realised.
The three Rs in action
Special situations opportunities are found in businesses across the market-cap spectrum. One sizeable company that has been in the rehabilitation phase for some time is transport operator FirstGroup, a constituent of the FTSE 250.
We initiated a position after FirstGroup brought in new management, sold its US divisions and settled numerous liabilities. Looking ahead, we believe it can benefit from the shift to a green economy – for example, through the ongoing electrification of bus networks.
Burberry, a component of the FTSE 100, is a holding that can be said to be in recovery. The luxury fashion house has lagged many of its international rivals in recent years, in part as a consequence of losing its brand’s “Britishness”.
A new management team, including a new chief creative officer, is now driving change. Although the business is maintaining guidance for high-single-digit revenue, Q4 2022 performance was notably encouraging – and the continued reopening of the Chinese market should deliver a further boost.
Finally, another FTSE 100 company, Smiths Group, provides a good illustration of revitalisation. Founded in 1851 as a watchmaker for the Admiralty, it has a range of industrial technology offerings but has struggled to achieve significant growth of late.
Under new management, Smiths sold the underperforming Smiths Medical and developed a sharper focus on sustainability. The company is now clearly seeing the benefits of such moves, with January’s half-year results showing record growth and impressive profits.
Why engagement is key
Unlike their school counterparts, the three Rs of special situations are not compulsory. A combination of all three may bring the greatest reward – but not necessarily.
For instance, it is not essential to take a position during the rehabilitation phase. We sometimes make an initial investment in a business only when recovery is already under way.
Special situations require close attention, which is why professional investors in this arena engage with companies’ management teams throughout the turnaround process.
Close engagement is especially important in the current climate. Decisions must be guided by the quality and vision of a business’s management – not by headlines, soothsaying and other noise generated by persistent economic uncertainty.
By looking to the long term and choosing carefully, investors can learn a valuable lesson about the merits of digging deeper and defying the herd.
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