Evolution not revolution

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Mitchell Fraser-Jones 16 September 2016 Est. reading: 6 min read

As an active, pragmatic fund manager with a flexible investment mandate, it isn’t unusual for Neil to evolve his portfolios over time, as the valuation opportunity set constantly changes.

In recent months, our Woodford Equity Income Fund roundups have revealed a series of disposals of blue-chip companies, which have led to a gradual reduction in the fund’s exposure to the FTSE 100. When we launched the fund in June 2014, 57.7% of its assets were invested in FTSE 100 stocks. Over time, this exposure has reduced to stand at 46.5% as at the end of August 2016. Meanwhile, the fund’s exposure to FTSE 250 stocks, Aim-listed companies and unquoted opportunities has slowly increased. In other words, the fund has gradually moved down the market capitalisation spectrum as the opportunity set has evolved.

Chart showing concentration changes by market cap of Neil Woodford's porfolios over time

Our investment approach always represents a relentless pursuit of long-term valuation anomalies. The investment disciplines that we deploy in this pursuit are consistent: a strong macroeconomic view informing high-conviction, valuation-based stock-picking, coupled with a strong focus on absolute risk and long-term fundamentals. Over time, however, these same investment disciplines have resulted in drastically different portfolios. Neil has utilised the full flexibility of his investment mandates to build distinct strategies to suit varying market conditions and, most of the time, portfolios that look nothing like the UK market as a whole. After all, as Sir John Templeton famously once said, “It is impossible to produce superior performance unless you do something different from the majority”.

Let’s travel back through history to see how Neil’s portfolios have evolved over time. The first real example of Neil building a portfolio that looked (and ultimately behaved) very different from the broader UK market was in the early 1990s. His portfolios then bear very little resemblance to the portfolios he manages now. At that time, Neil had positioned his portfolios full of domestic cyclical businesses, primarily engineering and export-focused stocks but also retailers, leisure companies and real estate.

At the time, these stocks were incredibly cheap and getting cheaper. After a prolonged period of consumption-led growth in the “Lawson Boom” years, the UK economy had ground to a halt. The government of the time should have been pursuing policies to revive it but instead it made things worse. The Conservative administration, led by John Major, was intent on maintaining the UK’s membership of the European Exchange Rate Mechanism (ERM), a preparatory fore-runner of the region’s single currency, the euro. As a ‘semi-pegged’ exchange rate system, all member states of the ERM had to pursue policies that would keep their currencies tied in a tight band to the deutschmark.

We often talk about exploiting market irrationality in our portfolios but this was really an example of exploiting political irrationality – trying to maintain Britain’s membership of the ERM with the UK economy gripped by recession was the economics of the madhouse. Essentially, government policy was defying economic wisdom by raising interest rates (and using FX reserves) to boost the value of sterling, when the UK economy was screaming out for much lower interest rates.

George Soros became famous as “the man that broke the Bank of England” but essentially, Neil was shaping his portfolios to benefit from the same outcome – both of them developed high conviction views that the UK government would fail in its attempt to maintain Britain’s membership of the ERM. Neither knew how or when but both recognised the situation as unsustainable. In September 1992, on Black Wednesday, the UK withdraw from the ERM, and an immediate reduction in interest rates followed, along with a dramatic rally in the share prices of all things cyclical on the UK stock market. The funds that Neil was managing at the time leapt from the bottom of the fourth quartile to the top of the first quartile and stayed there for some time.

Today, we live in a different world – a very different economic environment and a very different valuation opportunity set. There have been various shades of portfolio in between, of course – be it a substantial weighting towards banks (yes, you did read that correctly) in the mid-nineties, or the ‘old economy’ stocks that were totally out-of-favour during the dotcom bubble, or the focus on global dependable growth that developed in the run-up to the financial crisis.

All of these portfolios were formed using the same tools and with the same aim – that of delivering attractively positive long-term returns to investors. In each case, they ultimately succeeded in that aim.

The equity income fund has evolved in the relatively short period since its launch but it continues to reflect the cautious view we have of the global economic outlook. We remain absent from the parts of the market that look most vulnerable to the economic headwinds and have focused the portfolio towards companies that can deliver sustainable growth in spite of them. Some of the larger cap businesses that have exited the portfolio still look capable of delivering growth but other opportunities, some of them in smaller, earlier-stage businesses, have surpassed them in terms of attractiveness and conviction.

This evolution will inevitably continue. The pace and direction of that change is impossible to predict, as it will depend on what happens in markets and in the global economy.  One thing we can be sure of, however, is that Neil will continue to invest with the same discipline and with the same aim of delivering the attractive long-term total return that investors expect. An attractive, sustainable and growing income stream will continue to be a vital part of that return.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address: 27 Old Gloucester Street, London, WC1N 3AX.

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