It’s a good question. Henry Flockhart, co-manager of the Artemis UK Special Situations Fund, explains how and why the fund bought the stock and why it continues to hold it.
Many people consider investments within a special situations fund the ugly ducklings of the investment world – sometimes the attractions of each holding are not immediately obvious.
You would expect stocks held by special situations managers to be cheap. We are looking for good companies working to resolve their problems, recover earnings and benefit from the potential of a valuation re-rating.
It can take time for this to happen. The market may fear it will not happen at all – this is often why these stocks have fallen out of favour. Low valuations provide a margin of safety, skewing the risk/reward trade-off in the investors’ favour.
But it is important not to assume that cheap means value. Investors need to be focused on the potential for a turnaround. For example, even though telecom companies may be trading towards the lower end of their historical valuation ranges, we steer clear as managements battle with limited organic growth and high leverage and capex requirements, resulting in unattractive cashflows.
Surprisingly, a focus on management teams implementing intelligent self-help measures to create value can lead you away from companies that tend to be found towards the deep value end of the spectrum and more towards those that would initially appear more at home in a quality growth fund.
Special already?
Next is one such example. The high street retailer is well known among investors for delivering consistently strong returns on capital and high profit margins.
One of the catalysts we look for in a turnaround story is a new management team capable of unlocking hidden value, but Next has had the same chief executive – Simon Wolfson – since 2001.
And no one is calling for a change here, with Lord Wolfson one of the most respected bosses in the country, famed for under-promising and over-delivering and for his astute use of share buybacks to boost shareholder returns.
But cast your mind back to September 2022. Following Russia’s invasion of Ukraine, a surge in oil & gas prices and the hangover from Covid led to the return of inflation. Domestically focused businesses were hit by rising costs of energy, wages and goods on one side and a squeezed consumer on the other. When the Bank of England started rapidly raising interest rates and it looked as if things could not get any worse, the government responded by putting Liz Truss in charge.
Although most people do not look back with much fondness at Truss’s 49 days in Downing Street, such periods of extreme volatility create opportunities for special situations managers to buy quality companies whose valuations are usually out of reach. Next was just one company we bought at the time, along with NatWest and Grafton.
Next has proved to be an astute purchase. We bought in when earnings per share for the year to January 2025 were expected to be £5.40 and the share price was about £47. Less than 18 months later, those earnings-per-share forecasts have risen to £6.10 and the share price is £83.50.
Recovery complete, you might say. So why do we still own it?
The three Rs
The lifecycle of a special situations company is split into three stages: rehabilitation, when management has identified problems and set out a plan to fix them; recovery, when management’s plans begin to produce results; and revitalisation, when the turnaround delivers revenue acceleration.
We would put Next in the revitalisation phase. It has moved through recovery in the past 18 months, and we believe it has evolved to offer a new growth opportunity.
While Next was previously regarded as a single-brand bricks and mortar retailer, Lord Wolfson has calmly transitioned the business away from high street dependence with sustained investment in logistics, website technology and brands.
The benefits of this investment are perhaps most apparent in Total Platform, through which Next has become an ecommerce leader.
Launched in 2020, Total Platform has opened up Next’s ecosystem to partner brands, allowing them to increase sales without onerous investment in warehousing, web design, cyber security or fraud detection.
Clients now include major international clothing brands such as Gap and Victoria’s Secret, with which Next has formed UK joint ventures. As unprofitable peers are forced to stop overtrading due to unsustainable delivery costs and pricing, it is likely to continue taking market share.
Next has also started purchasing equity stakes in other brands such as Reiss, Joules and JoJo Maman Bébé, and there is the potential for further international expansion beyond northern Europe and the Middle East, where it already has a strong position.
If there is a lesson here for investors, it is not to sell your special situations stocks too quickly. A good portfolio will have a blend of companies at various stages in the transition from rehabilitation to recovery to revitalisation.
Still a special situation?
Would we have invested in Next had it not been for the buying opportunity caused by Trussonomics and the cost-of-living crisis? It is difficult to say. We probably would not have bought as much of it as we did.
But if our view is that the earnings of a company are going to be materially higher than the market consensus in three to five years’ time, we are not going to turn away. Nor are we going to sell too soon.
Ultimately, a special situations investor is looking for opportunities to buy swans when others shun them! When you find a good company – and Next is definitely in that camp – we think it pays to see it right through the 3Rs journey to success.
