TRENDS: Special Appeal of Natural Selection

Special situations investors harvest the casualties of the many re-financings. But the stockpicker still requires skill and judgment to get it right because not all companies will survive.

Stockpickers must understand that "value" in stocks is not enough. Any investor who picks stocks on this criterion alone will regret it. Many stocks are still not expensive, even after the remarkable run since March. But in this demanding economic environment many will go bust - and get a lot cheaper still.

If this view is right, then flexibility in stock selection will be vital. Using an unconstrained approach, "special situations" investing seeks out the most attractive stock opportunities and constructs a portfolio that reflects conviction. Unencumbered by the benchmark or the market cap of a stock, and using experience and judgment, special situations managers aim to cover territory often ignored by most investors.

A solid business franchise is a pre-requisite of any special situations share purchase. Thereafter it is down to the judgment of the fund manager to determine the absolute value of a company, and hence the potential reward - before mainstream investors, often encouraged by a benchmark weighting, turn their attention to it.

To do this successfully, fund managers need to understand the inherent value of a business and the upside that a particular management team can deliver, often based on experience. The reward is recovery in the earnings of a stock, as well as a re-rating.

Special situations managers should take a pragmatic approach and not restrict themselves to "value" or "growth". Instead, they should pick stocks on their fundamentals. Managers must spend time meeting companies' management, and trying to identify the people who can change businesses and improve returns.

A key focus is to identify businesses which, although fundamentally sound, have been through a period of disruption or poor trading. Often these situations require new management to sort out these difficulties. If much of the expected return is based on what the management can control, then returns become more realistic as they are not dependent on the vagaries of the economy.

Most such opportunities have been in the smaller company area of the stockmarket. But as value has appeared in larger companies, and as the economic climate has adversely affected the smaller company sector, most special situations funds have moved up the size scale over the past two years. An equal split between the FTSE 100 index and the rest of the market has been typical - although distressed and special situations have seen many funds move more towards a ratio of 40/60 in large/small caps recently: more traditional hunting grounds. Value in the mid cap and smaller company areas is more apparent. The high number of re-financings has allowed professional investors favourable entry into several attractive situations, mostly at the smaller end of the market cap scale.

But whatever their market cap, the prudent and committed investor must choose his stocks with great care. On what grounds? An important one is debt. It is essential to understand the dynamics of a company - the risks. For instance the combination of operational and financial gearing is the "death spot" for companies, whatever sector or market a company is in. Financial leverage is fine in a company with predictable cash flow. It is dangerous in a company with a more cyclical earnings stream. By focusing on a business's cashflow and balance sheet, a special situations fund can limit absolute risk by avoiding the "torpedoes" that really affect performance.

This said about debt, special situations investors realise that the exception can be as important as the rule. A good example of this is Ashtead, an equipment hire company operating mainly in America. It is an operationally-geared business that is going to make no money over the next couple of years. But what it will be doing is generating at least pound 100m of cash in that period. Although it does have debt, it also has sensible covenants that were put in place by a management team that understood the nature of the cycle. Ashtead is not going to have the banks banging on its door and making life difficult.

Similar "special situations" abound. A plethora of re-financings and re-structurings are offering opportunity. Some re-financings are for companies that can exploit the problems of their competitors. A good example is Debenhams, whose recent fund-raising not only improves its balance sheet but also gives the management funds to exploit the problems within the retail sector. Schadenfreude, or taking delight in others' misfortunes, can make for profitable investments - another retailer's loss may be Debenhams's gain.

Another example is the banking group Close Brothers. The company received bid approaches in late-2007 and early-2008 which prompted a re-think for the group. Close has been quietly refocusing under strengthened management, de-emphasising volatile transaction- related activities in favour of more stable lending and wealth management. The business is strongly capitalised with a healthy deposit base and a risk-averse approach to lending. In the meantime, it is paying investors a handsome yield.

Furthermore there is London Stock Exchange (LSE). With Clara Furse as its chief executive officer (CEO), the business was struggling. It was the subject of several hostile bids and Furse missed her chance sending these off. As a result, LSE lost its way. It now has a new CEO, Xavier Rolet, an ex-banker who understands what his banking customers want. And, a great attraction, LSE's shareholder base is irregular. Following the bid activities of last year, it has Kuwaiti and Qatari investors on its register. It also has several Italian banks, following the purchase of the Italian Stock Exchange. That means the shares are under-owned in Britain, which is something investors are able to exploit.

These are just three of many companies whose potential is great. In these testing times of corporate Darwinism, some companies will not just survive but will thrive. The vital question for special situations managers remains: which ones?

DEREK STUART co-manages the Artemis UK Special Situations fund

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