Investing in disaster can make you rich

Funds that invest in companies that are struggling or facing difficulties can reap unexpected rewards

With stock markets across the world remaining turbulent, deliberately seeking out and investing in troubled companies seems a wilfully perverse investment approach. But that is what a number of investment funds seek to do, often producing strong, if erratic, returns.

With stock markets across the world remaining turbulent, deliberately seeking out and investing in troubled companies seems a wilfully perverse investment approach. But that is what a number of investment funds seek to do, often producing strong, if erratic, returns.

Recovery funds and special situations funds follow the long-established City mantra of buying shares at the time of maximum pessimism. Recovery funds typically invest in companies whose shares are considered undervalued and likely to bounce back in value. These shares may be undervalued for many reasons, for example the company's sector generally may be struggling, although the business itself remains strong. Until recently, Marks & Spencer was seen as a classic recovery stock, with its shares trading low and a bounce back expected. But it has since given a clear demonstration of the dangers of investing for recovery, by continuing its slide downwards.

Special situations funds have a much wider remit. They invest in companies that have survived difficult trading conditions, and look set to take off. "Special situations can cover almost anything," says Alan Miller, fund manager of Jupiter UK Special Situations. "I am looking for well-managed, undervalued, high quality, high growth companies that for whatever reason are out of fashion but have significant long-time appreciation potential. I do not target companies that are being taken over, in terminal decline, or that have seen their shares slip following consistent bad results."

Miller says companies may be undervalued for many reasons. "Investors take a long time to change a negative opinion about a company. The business or management may have improved, but there is often a lag before the share price reacts. Sometimes the company only slips briefly, but the shares are marked down very aggressively for quite some time."

Financial adviser Andrew Merricks, partner at Simpsons of Brighton, says recent disappointing performance has made recovery "a horribly unpopular tag that has scared many investors away". Some funds have had a particularly hard time over the last five years, he says, notably Equitable Special Situations and M&G Recovery, which both grew little more than 60 per cent each over the period, according to figures from Micropal. At least Equitable has picked up over the last 12 months, growing 19 per cent, while M&G remains in the doldrums at 3.49 per cent. For a strong performing recovery fund you have to look to the US, and M&G American Recovery, which grew 147 per cent over the last five years.

As a mark of how far the recovery tag has fallen from favour, Fidelity Investments recently renamed its remaining recovery fund Fidelity UK Aggressive. The name change came at the request of its fund manager, Glen Pratt, says Julia Edwards, Fidelity's fund analyst. "He found that recovery was a very restrictive mandate and was forced to work within a limited universe of stocks, about 20 per cent of the total UK market. A lot of the companies he was looking at had long-term fundamental problems and were struggling for a good reason. Many were simply bombed out."

Performance has picked up lately, and the fund shows 30 per cent growth over the last 12 months.

Gavin Haynes, investment director with Whitechurch Securities, says the greater freedom given to managers of special situations funds makes them much more attractive to investors, and several funds are well worth a punt. Some have enjoyed tremendous performance over the last five years. Fidelity American Special Situations grew nearly 400 per cent, while Solus UK Special Situations grew 344 per cent. Solus even managed 86 per cent over the last 12 months, a huge showing in the current investment climate.

Haynes recommends Jupiter UK Special Situations. "Jupiter has lost some fund managers recently but Alan Miller is still in charge, and has done very well since launch through fairly aggressive management." The fund has grown 71 per cent over the last three years.

He also admires long-serving Fidelity fund manager Anthony Bolton, whose funds include Fidelity Special Situations. But he says anybody investing in special situations funds must do so with their eyes open. "There will be times when you're fund will look fantastic, and others when it looks pretty awful. These funds do have a place in a larger portfolio alongside steadier blue-chip companies and high-growth technology stocks, but are best left to the sophisticated investor."

Special situations funds do provide useful diversification when growth companies fall out of favour. "At such times investors search for value, as we saw between March and July this year, and some special situations funds can do well. But Fidelity and Jupiter aside, I am not a big fan," says Bolton. Recovery funds don't interest him at all. "Recovery funds have a very narrow investment remit which means you miss out on large areas of the market. A lot of the more traditional recovery funds don't allow you to run your winners. They look for undervalued companies and when they recover they sell them, which is not much help."

James Dalby, investment expert at Bates Investment Services, only recommends special situations funds to clients with large portfolios who are looking to diversify their holdings with something a little more specialist. "While some companies in recovery may represent a good buying opportunity, I don't think most investors should necessarily chase them. A good fund manager should always be on the lookout for good opportunities. These funds may suit more experienced investors, but are inappropriate for first-time investors," he says. Current stock market woes, if anything, only add to the risks. "Turbulence can hamper recovery stocks as much as any other stocks, maybe even more so, as it can prevent them from fighting back."

Jamie Ware, managing director of Churchill Investments, says most investors will do better with straightforward growth funds such as ABN Amro UK Growth or Baring UK Growth. "With these funds the manager can invest in recovery stocks and special situations when the time is right, but not otherwise."

Those looking for aggressive growth should seek out a good smaller companies fund. He recommends Edinburgh UK Smaller Companies, whose manager Alistair Currie has a strong 10-year track record, and the UK Smaller Companies fund run by newcomers Artemis.

Finally, not all recovery and special situations funds go by these names. The highly popular Gartmore, the European Selected Opportunities fund, which grew 226 per cent over the last five years, falls into the Micropal definition of recovery or special situations funds.