In football, ‘a game of two halves’ is a saying sometimes used by managers to characterise a match in which their team has endured contrasting fortunes. Although the worlds of football and fund management do not often overlap, the saying does quite accurately reflect the fortunes of the Woodford Equity Income Fund since it launched in 2014.
While this remains a relatively brief period over which to judge the success or otherwise of an investment strategy with a much longer investment horizon, the fund has delivered broadly what it sets out to: an attractively positive total return since launch, albeit, at the time of writing this is slightly behind that of the FTSE All Share index – the broader UK stock market index against which the fund’s performance is often compared. (Source: FE Analytics on a total return basis in UK sterling from 19 June 2014 to 20 December 2017. Past performance cannot be relied upon as a guide to the future.)
As an actively-managed fund which takes high-conviction positions in individual companies based on their individual merits, the fund usually looks and behaves very differently to the index. For example, in the second half of 2014 and throughout 2015, the fund delivered a very attractive return while the UK stock market was broadly flat.
More recently, however, in 2016 and in particular, in the year just about to end, market conditions have been much more challenging for the fund. Performance has been almost the opposite of what we had seen in the first eighteen months, with returns from the fund being broadly flat, against the backdrop of a steadily rising market. The road towards long-term outperformance in a volatile asset class is rarely a smooth one, but the extent of the difference in performance characteristics in these two periods has been unusually extreme.
One of the key reasons for this is sentiment, which always plays a part in short-term stock market behaviour. As active fund managers, we combine rigorous fundamental analysis with our perspective on the long-term macroeconomic outlook, to identify companies to invest in at compelling valuations. Conversely, the approach aims to identify overvalued stocks as ones to avoid. This fundamentally-based approach works very well in the long-term because, over sensible time horizons, fundamentals are all that matter.
In the short-term, however, sometimes sentiment takes over from fundamentals as the main driver of stock market behaviour, and in conditions like these, our fundamentally-based approach tends not to work quite so well. Typically, these periods tend to last only a matter of weeks or months – but sometimes, in extreme market conditions, they can last for somewhat longer and that is what we have seen over the last couple of years. Indeed, in this era of extraordinary monetary policy and ‘easy money’, global stock markets now exhibit bubble-like characteristics, with many investors seemingly forgetting about valuation risk in their desire to chase the market higher.
That is not to say there haven’t been some stock specific problems in the portfolio this year – there have, with Provident Financial, in particular, suffering a significant operational setback in the summer from which it is still recovering. We wrote extensively on this subject at the time and have continued to keep investors up to speed with events as the year has unfolded. To put this into context, however, Provident Financial accounts for broadly one-third of the underperformance against the index this year. Clearly, with the benefit of hindsight, performance from the fund would have been significantly better if we had not held Provident Financial in the portfolio, but the data suggests that the impact of broader market behaviour has been a much more influential force than stock specifics.
Elsewhere, Allied Minds, an intellectual property commercialisation business, performed poorly following its decision to halt funding to seven of its subsidiary businesses. From our perspective, the long-term investment case in Allied Minds has been built around its more promising subsidiaries in which we have substantial confidence. These include Federated Wireless, Precision Biopsy, Scifluor Life Sciences and Spin Transfer Technologies – we have co-invested directly in each of these businesses and several others, all of which are, in our view, significantly undervalued and offer very substantial long-term growth potential. So, although the recent share price performance of the parent business has been disappointing, we remain confident that it will deliver attractive returns and have retained the position within the portfolio. Indeed, in our view, Allied Minds has never been in better shape and yet its share price is pretty much as low as it ever has been in its reasonably short life thus far as a quoted business.
Meanwhile, the portfolio’s largest holding, AstraZeneca, had a volatile summer, following the release of interim data from the Mystic clinical trial which is investigating two of the company’s immuno-oncology assets in a lung cancer setting. As Neil said at the time, the financial results that were simultaneously released, “continue to demonstrate good progress towards the strategic goals which the management team has communicated clearly to shareholders and the market.” The market, however, seized upon the disappointing interim update from this high profile trial, to send the shares down 16% on the day of the announcement. It is important to remember that this was an interim update on the Mystic trial, based on a ‘progression free survival’ endpoint which was not met. It is not a drug failure – in fact, the trial was designed to show an ‘overall survival’ benefit in patients and there are a number of reasons to remain confident of a more positive outcome from the trial when it completes next year. In the meantime, although AstraZeneca continues to be cited as one of the ‘problem stocks’ that have blighted a difficult year for the fund, it is interesting to note that, over the year as a whole, AstraZeneca is one of the more positive contributors to the fund’s performance. Reality can sometimes be very different to perception.
Elsewhere among the positive performers were Burford Capital and Purplebricks. These are both young, dynamic businesses that are proving highly disruptive in their respective industries and their operational success has been rewarded by their share prices more than doubling this year. We are confident that both companies can continue to grow rapidly in the years ahead and, in the context of this growth, their shares continue to look profoundly undervalued.
Indeed, for the most part, the companies in which the fund has invested have tended to perform well operationally, delivering exactly what we had hoped they would in terms of profits, earnings, cash and dividend growth. This operational progress has not, however, been rewarded with higher share prices simply because they are not winners in the stock market’s popularity contest. Imperial Brands and Babcock International stand out here as prominent examples – both have delivered decent growth this year (8.6% dividend growth from Babcock, 10% from Imperial Brands) but their share prices are, at the time of writing, down 26% and 11% respectively.
This is a consistent feature of bubbles – there is always a subset of the market which falls out of favour as investors increasingly pursue the excitement that exists elsewhere. In the dotcom bubble of the late 1990s it was the ‘old economy’ stocks, like utilities, food producers and tobacco companies that fell hugely out of favour, as the market became obsessed with internet stocks that offered exposure to the ‘new paradigm’. Today, in the UK stock market, it is domestically-focused stocks which have become profoundly unloved and undervalued.
The fund has increased its exposure to these businesses as they have become cheaper, to exploit a compelling valuation opportunity. This has meant revisiting parts of the market from which Neil has been largely absent for the last 15 years, including banks (Lloyds), housebuilders (Barratt Developments, Taylor Wimpey) and real estate (British Land). We are very confident that this will prove to be a rewarding strategy when the bubble bursts, which we believe it inevitably will.
Predicting the timing of such an outcome is of course fraught with difficulty. Already, however, there are certain events starting to happen which we believe will threaten the cosy consensus view of the global economy that has crept steadily into markets over the last two years. Whether it is higher US interest rates coupled with the gradual withdrawal of quantitative easing in the US, signs of changing priorities from Chinese policymakers, or indeed the UK economy’s continued defiance of expectations of a slowdown, there is already ample evidence to suggest a much more favourable market and economic backdrop for the fund’s performance in 2018 and in the years beyond it.
Another saying in the world of sport suggests that, ‘you are only as good as your last game’. We acknowledge that performance has been disappointing recently but we understand the reasons why and are not complacent about the journey ahead. With over thirty years’ investment experience, however, and a tried and tested approach, we are confident that the fund is very well-positioned to deliver the attractive and positive long-term returns going forward, to which investors have become accustomed over a very long period of time.