As the chart above demonstrates, however, the fund did not keep pace with the broader market, even if we strip out the impact of these index heavyweights. The fund’s performance has also been impacted by adverse share price performance from some parts of the portfolio – some of this is linked to negative fundamental developments but, importantly, much of it is not.
One stock stands out as a poor performer and it has also been the source of a lot of questions from our investors in recent weeks. Capita was a big position in the portfolio as we entered 2016 and its share price more than halved over the course of the year. A series of disappointing trading updates in the latter part of the year have completely undermined market confidence in the business, and indeed, the credibility of management forecasts.
We have been disappointed and surprised by the apparent vulnerability of Capita to the weak trading in its more cyclical divisions (which are a small part of the overall business). The impact of this trading weakness has been exaggerated by a perception that, as profits have fallen, the company’s balance sheet has become stretched.
Management has announced the disposal of its asset services division, which should help to address these balance sheet concerns. Furthermore, we believe the market has over-reacted to the series of profit warnings. In our view, the share price now profoundly undervalues the fundamental long-term attractions of this business. At times like this, it is essential that one does not compound the impact of a fundamental disappointment through an emotional reaction to a share price fall. We recognise that it will take time to rebuild credibility and value at Capita, but we are prepared to be patient.
There were some bright spots elsewhere in the portfolio. Shares in Burford Capital – a young litigation finance business and a great example of the benefits of our patient capital investment approach – more than trebled in 2016, as the market finally started to acknowledge the value that has been created by its impressively astute management team in recent years. Our tobacco holdings also delivered a positive contribution to performance for most of the year, albeit some of this was eroded in the final quarter as the momentum-driven market conditions intensified.
Regular readers of our blog have also asked why we continue to be overweight in healthcare. It’s a sector that we believe offers investors an exceptional opportunity not least because of its attractive fundamentals. The industry is becoming more incentivised to bring forward innovative treatments that address the heavy burden of healthcare costs on the economy. As a result, we see a lot of value being stored up in the sector and there are some very promising drugs coming through from the pipelines of both small biotech and large pharma companies. Going forward, as a result of the market’s failure to acknowledge this progress over the last eighteen months, it is plausible that value starts to be recognised in the form of more M&A activity in 2017. Consequently, we believe that there is considerable long-term value within the healthcare sector and we have positioned the portfolio to capture this opportunity. We will be writing in more detail on the attractive fundamentals of the healthcare industry in the near future.
In conclusion, despite the challenging market conditions we have witnessed and some surprising political events, nothing we saw last year persuades us that the portfolio should be positioned differently. The narrow momentum-driven rally that we have seen has added risk to certain parts of the market. In particular we continue to avoid the oil & gas and mining sectors where, despite the rally in commodity prices, dividends are still vulnerable and the fundamental backdrop for prices remains weak. This positioning was unhelpful in 2016 but we’re convinced it’s still appropriate to avoid them.
Instead, the portfolio remains positioned towards attractively-valued businesses with significantly more control over their destiny. This control, generally speaking, has delivered some considerable positive progress in 2016 and this progress will ultimately be reflected in share prices, when fundamentals reassert themselves as the predominant influence of share price behaviour. As such, we look forward to 2017 and the years beyond with great confidence.