The worse the news the better for anyone looking to make good money out of recovery

The M&G Recovery Fund, launched in 1969 to buy the shares everyone else was selling, is now the UK's third largest unit trust with 150,000 unitholders and pounds 1.4 billion under management.

Its size limits manoeuvrability and presents a challenge, but not an impossible one, says its manager Richard Hughes. Big stakes and dramatic recoveries are needed to maintain outperformance, but so far the market keeps throwing up opportunities.

The fund's shares are currently languishing a little at 25p after touching 33.5p earlier this year. But average annual compound growth rate since launch is 20 per cent and capital growth is the objective.

The philosophy of the fund has been refined over the years, says Mr Hughes, but the starting point is still to look for companies in trouble. The bigger the bad news appears - preferably on the front page of the Financial Times - the better.

"Investors see bad news, panic and sell. I then look and start to do my work," says Mr Hughes.

First he has to decide if there is a solution, or if the company is in an irretrievable mess. If there is hope, there must also be the prospect of the shares moving up strongly as problems are solved.

The three elements of recovery are usually a change of management, an injection of capital and the passage of time, explains Mr Hughes.

The passage of time theory, combined with a change of management, came spectacularly right in the case of Guinness. When Ernest Saunders left in disgrace and Sir Anthony Tennant went in to head a new team, the company was being threatened by a pounds 1 billion lawsuit from Argyll.

A few years down the road, profits have rolled in, the shares have appreciated several-fold and the scandals of the past have faded into the background. From a low point of around 120p late in 1987 Guinness shares appreciated fivefold to touch 600p in 1992, although their subsequent performance has been more subdued and the shares this week are trading just below 460p.

The Recovery Fund by its nature courts the danger of holdings going bust. Some 23 have done just that in the life of the fund, a tally of almost one a year.

The biggest failures for Mr Hughes, who has managed the fund for eight years, were Lowndes Queensway and Davies & Newman - each of which represented 1 per cent of total assets. However, he has avoided some of the biggest nasties of recent years including Polly Peck, British & Commonwealth and Coloroll.

The flipside to the danger of one of the investments going bust is the enhanced likelihood of a share being taken over, usually at a significant premium to the current market price at the time of the bid.

The fund's largest holding is presently TSB, whose shares have soared since the announcement of the merger with Lloyds Bank. From a low of 217p they soared to a peak of 417p and are still within touching distance of pounds 4.

Other winners this year have included Fisons, taken over by Rhone Poulenc Rorer, and Kleinwort Benson, which was acquired by Dresdner Bank.

Despite the boost provided by takeovers, M&G has a house policy of not supporting hostile bids. They are expensive and often work out badly for both sides, says Mr Hughes.

"We accept agreed bids and bids which have gone unconditional, but we believe there are sound commercial reasons for not accepting hostile bids," he adds. He points to the examples of Molins and Birmid Qualcast. Bolstered by a 17 per cent stake held by M&G Recovery Fund, Molins fought off five takeover attempts in four years, the last at 275p a share in 1990. Retaining its independence, the company has gone on to greater glory and its shares reached a high of 825p this year.

Birmid Qualcast, supported by M&G, saw off the first Blue Circle bid in 1988 at 380p a share, but then accepted the second a few months later at 450p.

As well as a time to buy, there is a time to sell. The fund holds investments for an average of five to six years, excluding takeover stocks which tend to exit faster.

Sometimes the fund loses faith. Mr Hughes saw the writing on the wall for Ferranti and managed to sell many shares before the company collapsed.

Sometimes the time to sell is when the investment has made up its underperformance and matched its peers. When a company's return on sales and capital are up to the industry average or its price to earnings ratio matches the stockmarket norm, there is a case for saying it has recovered.

The third option is to wait for outperformance. Mr Hughes points out that there is a virtuous circle associated with recovery stocks. As companies emerge from the mire, investment rises, profits go up, morale improves and good people are attracted. Former "dogs" often go on to be stars.

It is important for the fund to capture at least some of that uplift, as the multiplier effect on a big stake is dramatic. The fund sold its 13 per cent stake in Standard Chartered Bank too soon, admits Mr Hughes, although it made a lot of money.

It bought into the between 50p and 100p in 1991, after adjusting for the four-for-one share split, and sold into strength - but missed the spectacular rise of the last six months when the shares rocketed to a high at 625p, although it too has since come off the peak to around 550p this past week.

Although the fund has no sector preferences, it tends to be overweight in manufacturing and light in oil and commodity stocks and people businesses. It is also biased towards medium and smaller companies with 70 per cent of its money outside the FTSE 100 companies.

Overseas holdings represent just 2 per cent of the fund and are unlikely ever to rise above 5 per cent, says Mr Hughes. "From time to time I'll dip overseas, if colleagues come up with a good idea," he says.

Mr Hughes is at his busiest in recessions when there is a glut of buy opportunities. The fund itself performs poorly in recession and shines in economic upturn.

It is presently at a halfway house, says Mr Hughes, with on balance more buy than sell candidates.

Rather than venturing into pastures new, the fund this year has been supporting rights issues and adding to existing holdings including United Biscuits, BICC and Lucas.

With the stockmarket quite high, Mr Hughes is being choosy about what to buy to ensure the right returns for the future. He is reasonably optimistic that with 2 to 3 per cent economic growth and 2 to 3 per cent inflation companies have a stable environment in which to prosper.

He keeps a watchful eye on the economic cycle to guard against buying too soon in a downturn and selling too early in a recovery. His goal of beating the All Share-index is no easy task with a big fund, so he keeps his fingers crossed that the years of recovery will continue to outnumber those of recession.

M&G Recovery Investment Trust is based at Three Quays, Tower Hill, London EC3. telephone 0171-626-4588.