Many of you have, understandably, asked for my current perspective on Capita, following its sharp share price decline earlier this week. It is not always possible to provide an immediate comment in response to events, nor is it always advisable. Having had a couple of days to reflect and consider what has happened, I would like to provide some context.
At the start of this week, Capita represented approximately 0.8% of the Woodford Equity Income Fund, and about 1.3% of the Woodford Income Focus Fund. Since the profit warning on Wednesday, Capita’s share price has broadly halved, which has clearly been unhelpful to recent performance.
Putting the share price reaction to one side for a moment, I am pleased that we have seen from the company what we thought would be coming. This is a complete reset for Capita. The new chief executive, Jonathan Lewis, has mapped out a clear new direction of travel for the business and it is one with which I completely agree. More focus, better leadership, better cost control, a stronger balance sheet (through a combination of disposals, dividend cut and a future capital raise) which will, in turn, lead to more investment in the business, an enhanced competitive position and a brighter future for its shareholders and customers.
This reset has been met with a massive fall in the share price from an already very depressed level. In the current market conditions, perhaps we should not have expected anything else. After all, Capita represents many of the things that this market loathes at the moment – it is exposed to the UK economy, it has a recent record of disappointment, it is an outsourcer.
This is the reality of what we have been writing about for some time now. Markets are being driven by momentum. Valuation is irrelevant – it simply does not matter in the stock market at the moment. The only question that ultimately matters to me when forming an investment judgement, is ‘what is the company worth?’. On that basis, it strikes me that a decision to sell Capita here is almost impossible to justify from a fundamentally-based perspective.
Some facts about Capita. In 2016, the company made an underlying pre-tax profit of £475m. It’s share price at the start of that year was £12. Current guidance from the company for profits in a depressed 2018 – a year in which the business is reset, will be investing in efficiency improvements and incurring a number of one-off costs – is in a range between £270-300m. The share price at the time of writing is 165p.
There are a lot of moving parts and other issues to consider but if this was all you had to go on you might think that, from the perspective of valuation, this is a little bit interesting. There are of course buyers of corporate assets that are not disciples of the momentum school of investing – I suspect that other businesses and private equity buyers will be circling Capita as I write.
I am not trying to make a silk purse out of a sow’s ear – this has been a poor investment, but it is one that has the capacity to become a significantly better one from here. There is much work to be done to turn the business around, but there is a clear plan and the project is underway. Discussions with all major customers have gone very well as have conversations with the Cabinet Office. The collapse of Carillion has catalysed the whole outsourcing sector to rebase its relationship with the Government, which also recognises the need for change, to reflect a fairer balance between risk and reward. (By the way, they are both outsourcers but the only other similarity between Capita and Carillion is the first two letters of the name.)
I would go as far as to say that the business will be in better shape at the end of 2018 than it was in 2016. It will have infinitely better leadership, a stronger balance sheet, better cash flow, more conservative accounting policies and a lower pension deficit.
The mistake I have made, albeit I didn’t know it at the time, was in owning Capita in 2016. It is not a mistake to own it now. And so, I will not be compounding the previous error by behaving in an irrational and valuation insensitive way now.
Whilst the stock market remains totally preoccupied with momentum and insensitive to valuation, we should all expect the environment to remain as challenging for the Woodford funds, as it has been since early summer last year. I will underperform in such market conditions as I have done before. Equally, however, we should expect rationality to return in an unpredictable way, as it has done always in the past. When this happens, share prices will adjust to reflect reality in the economy and in the businesses that thrive and prosper within it. In the meantime, I would be doing you, my investors, a massive injustice if I was to abandon the investment discipline that has guided me for 30 years in this industry.