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With so many uncertainties still plaguing financial markets and the global economy, the remainder of 2008 could be difficult for investors. The full effect of the credit crunch is still unknown, and investors are fearful about an economic slowdown in the UK that threatens to become a recession. Despite the UK stock market declines of the past six months, after five consecutive years of gains the level of complacency that still exists among investors remains cause for much concern.

The abundance of cheap credit as a result of low interest rates was a key driver of the prolonged rally in equities and the possibility of this disappearing has prompted investors to reappraise their assessment of risk. While interest rate cuts in the US and the UK have provided a short-term reprieve in restoring investor confidence, lowering the cost of money does not provide a long-term solution to the world’s financial woes. The problems that have been spawned from excessive debt, particularly among consumers, have not simply disappeared and may have only just begun with the US sub-prime mortgage crisis.

Commentators therefore maintain a sense of trepidation about the broader economy as we move further into 2008, but their cautious view on the world has not dampened a huge enthusiasm for individual recovery candidates. These types of investors assume the economy provides no benefit to the companies they invest in. Thus with a focus on corporate, not economic recovery, there continue to be plenty of promising stock-picking opportunities regardless of the economic environment.

First and foremost, recovery investing demands a sustainable investment strategy. It is important to look for companies whose recovery potential lies in their own hands, and not those reliant on a supportive economic background. These companies must be able to recover through their own efforts, underpinned by competent management, a sound corporate strategy and strong business fundamentals.

Mid-cap engineering group Ivensys is a good example of a company firmly in control of its recovery potential. Since the days of over-expansion and excessive debt, the company has embarked upon a restructuring programme and improved its finances, paving the way for a recovery to take place. The management team has demonstrated the ability to guide the company back to health, and there is a firm cause to remain optimistic about its future prospects.

It is not just mid caps that make good recovery investments either. Recovery candidates come in all shapes and sizes, from the smallest market minnows right up to FTSE100 heavyweights. Indeed, there are a wealth of opportunities among large companies at the moment, especially following years of underperformance relative to their smaller peers. As such there has been a case for buying shares in unloved but very interesting blue-chips such as HSBC, GlaxoSmithKline and Unilever. The large end of the market-cap spectrum offers up a wealth of quality companies whose global franchises and growth prospects are undervalued by investors. Furthermore, these shares do not pose any problems in terms of liquidity. Thus the essence of recovery investing lies in stock picking and an investment process that can be applied consistently to identify investment opportunities across the entire market-cap range.

As every corporate recovery story takes time, a long-term approach is crucial in order to share in companies’ recovery as they work to improve their fortunes. Three to five years is a realistic time frame required by the management of “unloved” companies to turn their businesses around. Investors have to be happy to hold companies for longer if necessary, if the process of corporate recovery still has further to go. The benefits of corporate recovery should continue to accrue to the shareholder until the process is complete and finally recognised by the wider market.

Take for example De La Rue, the world’s leading non-government printer of bank notes. Investors could have bought the shares in early 2000 at 350p. While the stock was plagued by a history of profit warnings as a result of over-capacity and ill-judged expansion attempts, there was reason to be confident the company’s restructuring plan would lead to a full recovery. Delayed orders provided a temporary setback in 2002 and 2003, but the appointment of Leo Quinn as chief executive in 2004 heralded a new dawn for the company. He installed a cost-cutting plan, built up a strong order book and generated huge amounts of cash flow, much of which was returned to shareholders in the form of buybacks and dividends. The stock has since soared to over 900p and the company’s future prospects remain strong.

De La Rue is a typical example of a situation where the market became too pessimistic about a company’s problems without considering its long-term prospects. From a shareholder’s perspective, it is essential to stay the distance. This is especially important in light of the volatility that early stage recovery holdings can be subject to as they go through periods of change, or during periods when the wider market may be experiencing greater volatility. Holding a healthy mix of companies at all stages of recovery, so volatility in early-stage holdings can be balanced by the more stable performance of companies in the later stages of recovery, means short-term market volatility should not be a concern for a long-term recovery investor. The ultimate aim is to share in embattled companies’ improving fortunes over the long term, as they return to favour with the market.

A recovery fund also benefits from an investment approach which is by nature contrarian – it buys shares when other investors want to sell them. Going against the herd requires conviction, however, and this is developed by maintaining a constructive, two-way dialogue with companies’ management teams as they work to turn their fortunes around.

For those who are a significant shareholder in the companies they invest in, the aim should be to maximise their potential for value creation by supporting them through the recovery process. Engaging in constructive dialogue with companies about management appointments, corporate strategy and financial structure is integral to this investment approach and can be done in a low-key manner behind closed doors. Common sense and patience are key to this process.

Given investors’ nervousness about the state of the economy, further periods of sentiment-driven market turbulence can not be ruled out. However, a long-term view and patient approach will continue to serve investors well over the long term. It is not all gloom and doom, either – lower share prices mean better buying opportunities for stocks where there is real conviction. Furthermore, company fundamentals will prevail over time and the recovery approach will continue to deliver competitive returns in the long run.

Tom Dobell is manager of the M&G Recovery fund