Three special situations set to become quality growth stocks

Investors love consistency in a business and often justify paying high valuations for long-term visibility of future cashflows rather than hunt for bargains in out-of-favour sectors.

But in our experience, many of the quality growth compounders of today were once ‘value’ or ‘special situation’ stocks themselves in years gone by. When I joined the Artemis UK Special Situations Fund in 2009, RELX’s core business of academic research was said to be threatened by open-access publishing, LSE was perceived to be over-exposed to volatile share-trading revenues and Compass Group was in the process of unwinding its over-expansion into unattractive, subscale catering markets. Yet each one had the potential to be transformed by talented management teams, which is exactly what came to pass.

As winter turns to spring, we highlight three out-of-favour stocks that could be about to wake from their dormancy; three ‘darling buds of May’ that we believe could blossom from the special situation stocks of today into the quality growth compounders of tomorrow.

Unilever

As a consumer goods company, Unilever has often been referred to as a ‘bond proxy’ in the past when it was a mainstay in many quality growth managers’ portfolios.

However, following an excessive bid for Haleon (the consumer goods division spun off from GSK), the credibility of Unilever’s board and management team was called into question and today the consensus view is of a company that has lost its way.

A change in senior leadership is often the catalyst for a fresh strategic approach, and we take opportunities to engage with new management teams when they are announced. This was the case when a new Unilever chief executive, Hein Schumacher, arrived in 2023, and a new chief financial officer shortly after.

The new management team quickly set about refocusing the business on its top brands in key markets, which is driving higher revenue growth, and restructuring the supply chain, to deliver higher gross margins.

The extra cash being generated by this strategy is being reinvested back into the marketing of its top brands, accelerating revenue growth.

Management has also announced plans to de-merge the ice-cream business, which doesn’t fit in with the rest of the portfolio, helping Unilever return to what has served it well in the past.

Together, we believe these changes should result in more consistent growth and unlock a re-rating towards that of the company’s international peers.

Babcock

Again, our interest in Babcock began with the arrival of a new management team, after their predecessors diversified away from its core defence operations, overpaying in the process and saddling the business with too much debt.

The first thing the new management team did was to initiate a far-reaching contract review which led to £1.7 billion of negative adjustments to the balance sheet¹, including contract write-offs and the impairment of goodwill.

Crucially though, despite the new chief financial officer’s reputation for conservatism (we knew him and the chief executive from their time at Cobham), they announced that the company wouldn’t need to raise equity. Instead, it disposed of £400 million of assets to refocus on defence and strengthen the balance sheet².

In 2023 the new management team had sufficient confidence to set targets for mid-single digit revenue growth with margins of at least 8%, higher than the market view of what was possible. Since then, the world has changed, with European countries committing to increased defence spending, offering further potential upside.

With improving margins, long-term contracts and a growing number of international opportunities, we believe Babcock’s prospects are attractive.

Smiths Group

While the previous two stocks are on the journey to becoming high-margin businesses with stable top-line growth, we think Smiths Group is largely there already.

Smiths Group is one of the last industrial conglomerates left in the UK and one of its businesses in particular is a standout performer: John Crane, which manufactures specialist mechanical seals for applications in industries such as oil & gas and chemical processing.

With much of its business based on aftermarket care, John Crane commands recurring revenues with high margins, while the mission-critical nature of its products means they benefit from strong organic growth.

However, John Crane sits alongside other divisions that are unrelated to it in any shape or form. Smiths Detection – which makes airport baggage scanners – is one of these. While it is a good business, its revenues tend to be driven by regulation, with new product cycles every eight or so years as new technology is rolled out.

In our view, this detracts from the stability of John Crane’s earnings and makes it difficult to get behind any one part of Smiths Group.

The good news is that following pressure from investors, the board has announced plans to break up the business. It will sell Smiths Interconnect, which makes electrical connectors, later this year, followed by a demerger or sale of Smiths Detection³.

This should focus investors’ attention on the long-term visibility of John Crane’s organic growth and margin progression, and could see Smiths Group close the valuation gap that exists versus its international peers.

It may not happen before the blossom fades from the trees, but we don’t think it will be long before other investors wake up and smell the roses.