‘Distressed’ UK value investments that could triple

Sam Benstead interviews Schroder Recovery manager Nick Kirrage about how he finds undervalued shares in the UK. He highlights a number of “distressed” shares that could become great investments, with the potential to double or triple in value.

Kirrage also explains why value investing will work over the long run, even though growth investing has performed better over the past decade.

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Sam Benstead, fixed income lead, interactive investor: Hello and welcome to the latest Insider Interview. Today our guest is Nick Kirrage, manager of the Schroder Income and Schroder Recovery Funds. Nick, thank you very much for coming into our studio.

Nick Kirrage, manager of Schroder Income and Schroder Recovery funds: Thanks for having me. It's a pleasure to be here.

Sam Benstead: Let's move on to the Schroder Recovery Fund now. This is a value fund, but what is value in your view?

Nick Kirrage: That's a great question because value has become quite a broad church over the last 10 years as a very big spectrum. For us, we're looking at typically the cheapest 20% or 30% of a market on any given valuation metric. The metrics differ; it might be a price to profit, price to earnings for a company, it might be price to book value or indeed a dividend yield or any other.

What they all have in common though is that valuation metrics funnel you towards areas where people tend to be scared or disappointed or fearful, and that's ultimately what value investing is to us. We are looking to those areas where there is a psychological disruption, where people are unhappy. Then we always say what we're trying to do with the recovery fund is we're trying to do what other investors don't, won't, or can't do, and invest in some of those diamonds in the rough that are long-term great opportunities.

Sam Benstead: Is the UK market good value today? This comes even as the market's recovered in the past couple of months, and we've seen US shares fall.

Nick Kirrage: There are a number of different themes. One of the things that's certainly on a knife edge is the perception of the UK domestically in terms of how strong or weak the economy is. That's led to a lot of businesses' income starting to fall, so we talk about businesses like general retailers or house builders or staffing companies, many of which tend to be kind of cyclically sensitive, several of which are kind of the canary in the coal mine and the bit that falls first.

What we tend to do when we're looking at these investments, macro investing is very hard. It's very hard to call the UK economy in the short or medium term. There are a lot of variables going on there and not even the OECD or the Office for National Statistics (ONS) knows. That's why they're constantly revising historic views on what GDP was three years ago.

What we intend to try and do is ask ourselves, what is already discounted in the share price? And the reason we're doing that is because if we can buy enough businesses with different drivers where a bad outcome is already in the shares, well, then if that bad outcome transpires, we shouldn't lose a huge amount of money for our investors.

But if any other outcome transpires, we will tend to make very good returns for our investors. What we do know is that over the long term, economies tend to push ahead, they do tend to grow, and that those periods of weakness tend to be shorter term rather than longer term. So, we're willing to be patient, and it does require a long-term investment horizon, typically, we would take a five-year investment horizon, you can make very good returns for investors that way.

Sam Benstead: And what companies have you been adding recently to the fund?

Nick Kirrage: On the staffing side, businesses like Hays (LSE:HAS) and Robert Walters (LSE:RWA), these are businesses that are economically sensitive and they're focused and they are seeing a lot of pressure at the moment. There's been a difficult environment, particularly with inflation. CEOs, management boards, are looking at their hiring practices and saying, do we need to bring on more people? Should we wait and see? Should we be a bit cautious? And these are businesses that are effectively sensitive and linked to those decisions.

So, we're seeing at the headline negative sales for those businesses in the short to medium term, which happens, they're cyclical, and as a result, that's feeding through to quite significant drops in profits in the short to medium term.

The great thing about these companies is that their management teams typically understand the nature of what they are, that there is a cycle. They tend to have very conservative financing bases because they don't know what's around the corner all the time, and they tend to take a long-term view. They also have very attractive cash characteristics where, as they slow, they throw off cash, and as they grow, they consume cash, which means that when things do slow up, if that happens very quickly, their financing position gets even stronger as things weaken, which is a combination that's very attractive and means you don't necessarily have to take huge amounts of risk even though things are slowing.

But we don't know how long it will take for them to recover and we are having to take a long-term view. But these are quite distressed shares in our view. Significant compounding opportunities, 100, 200%-type upside.

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Sam Benstead: The UK market is often thought of as cheap. Do you think that argument holds, particularly as we've had a bit of a recovery over the past few years, and also the US has now come down in valuation a little bit too?

Nick Kirrage: Yeah, it has and so people are starting to ask that question. For me, the thing that's fascinating is if you look at a long-term chart versus, say, the US and you looked at either the index or probably more sensibly the valuation of the UK versus the US, and you looked at what we've seen in the last eight weeks or so, the chart goes like this [up] and then goes [down], so you can hardly see it.

So, there is a very important question here, which is what is driving this? How enduring is it? And how much is this going to go on? Because I think the narrative for the last, certainly the last 10 years and probably 15 to 20 years, has been that of US exceptionalism. You hear this. It's a more dynamic economy, it's more dynamic place. That's how it's managed to generate some of these globally consequential businesses. The Googles and Metas and NVIDIAs of the world. Is there something special there that isn't elsewhere that means that that market should always command a premium?

I think there are factors that have been to do with the background, the backdrop, how business friendly they are, and management friendly and that kind of thing that mean that actually those markets are very dynamic and will continue to be so. Having said that, a little-known fact is that in terms of new business creation, the UK is third only behind China and the US.

We have innovation here, and we are starting to tackle some of the things that have held us back in terms of the regulation, the market, the backdrop, the stimulus. Will that continue? Can it endure? Question mark. But come back to what I was saying about, it's what you pay for the shares. Most of these shares, even after a bit of improvement, really don't discount any further improvement, so you get a free lunch in terms of if that happens.

Sam Benstead: You also manage an income fund. So, is a high dividend yield an important factor when assessing the value of a share?

Nick Kirrage: That's a very good question. You don't have to. And the reason is, with more deep value, or we would call our deep value offering ‘recovery offering’, quite often you're investing in businesses where the risk is increasing because those are potentially the highest returners, but where that risk is high.

So, businesses will be cutting dividends in order to shore up their finances to make sure they survive through to the future. And we'd be advocating they do that strongly, working with management to say, do everything to try and retain cash and make sure you've got this runway to do the hard yards and recover.

But that isn't every investment. What you tend to find is there are a number of businesses that become very cheap where we look at them today and would say, actually, we think that dividend's totally sustainable. We don't understand why the market's looking at this and saying, just ignore this.

For a long time, a good example of that was banking, where we felt these were businesses that had been, yes, they'd got it all wrong in the great financial crisis. But in Covid, they'd shown how much stronger they were and how much better the balance sheets were, and people were looking at those dividends and they were yielding very high levels. Yet we still thought they were recovery investments. The fact that many of those shares have doubled subsequently. I think when you're looking for deep value investments, people think that you can only find that if you go down to the small or mid cap. We sometimes say, it's deep value hiding in plain sight.

A number of those stocks, which were some of the biggest in the market beforehand, but have still gone on to double. So, opportunities within them. Today, our recovery fund has a very decent yield on it. That isn't the case at all times. Quite often we get our returns from share prices rather than from income. But today I would say, having managed money in the UK for the last 25 years, this is one of the greatest opportunities in terms of being able to have your cake and eat it in terms of having income at the same time as recovery potential.

Sam Benstead: Do you still hold on to those financial shares that you've mentioned and linked to that, how do you know when to sell a company?

Nick Kirrage: Well, that's the great question. Someone I worked with once said, don't fall in love with the shares because they can't love you back. And that's very true. I think when you get into an investment, before you get into any investment, you should have a strong view on what you think that investment is worth. You might be wrong, but it's a good discipline to say, this is what I think the shares are worth.

Obviously, as things change, evolve, the shares improve, hopefully. You might change those views. You might evolve those views, but it's very important to not fall in love with shares because ultimately, I hold to the fact that you only make money when you sell a share. It's a book value gain, it's a paper gain until you sell it and lock it in and reinvest it elsewhere, and so you have to be able to understand when you're going to sell it and to go through with selling it, so that you can reinvest that.

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Sam Benstead: Over the past 10, 15, 20 years, growth investing has been the more popular and successful way of owning shares. But why should investors actually own some value funds too?

Nick Kirrage: I'm a value investor, so I've made my entire career, I've bet my entire career that the drivers that mean value works over the long term haven't gone away, that humans, which ultimately this is a psychological approach, your buying into kind of fear and uncertainty on the basis that those things are kind of transient and that most businesses recover over time, not all, but on average they do and that you can benefit if you're willing to be brave and take a long term and a diversified portfolio view.

I would say that none of those things have changed in my mind. There's no need to reappraise that. Humans, I still see them behaving like humans day to day. But I understand that growth has done extremely well and value has done less well over the last 10 years. A lot of people would look at that and say, why would that change? In that environment, what I would to say to most people is, I would see value as insurance policy.

Most people would not put all their eggs in one basket, no matter how convinced they were that the narrative that drove the last 10 years is going to continue. I would increasingly see us as the offset and one in which we can continue to generate and give you a good return over time. There isn't a huge cost to that insurance policy. Hopefully over time, we can earn your trust and a bit more of your money and capital going forward. But for now, I'd see us as this is about diversifying into multiple approaches, all of which can help you generate a return.

Sam Benstead: Finally, the question we ask all our guests, do you personally invest in the Schroder Recovery Fund?

Nick Kirrage: Absolutely, wouldn't have it any other way and I think all fund managers should, so I definitely, definitely put my money where my mouth is.

Sam Benstead: Nick, thank you very much for coming into the studio.

Nick Kirrage: Thanks for having me, Sam.

Sam Benstead: And that's all we've got time for today. You can check out more Insider Interviews on our YouTube channel where you can like, comment, and subscribe. See you next time.