Nothing in investment comes close to the predictive power of valuation with respect to future returns. This is profoundly intuitive, even common sense, and all of us use valuation principles in everyday life. But, in the investment world, valuation principles don’t always guide investor behaviour. When financial markets lose touch with valuation principles, accidents always happen and crowded trades always blow up. This has happened throughout financial market history and has affected many different assets as diverse as tulip bulbs, property and of course most frequently, equities. Ultimately, the inevitability of a correction in overvaluation is certain. The timing of that correction, unfortunately, is not.
That is why investors get sucked into asset bubbles. Investors lose their perspective on valuation (the fear of missing out), crowd-like behaviour subjugates normal valuation discipline and momentum takes over. Investors rush into stocks that have risen in price and, typically out of those that have fallen, insensitive to valuation. Investors feel safe following these trends and, in the short term, that is likely to be a successful strategy because, by definition, it is being followed by the majority and to stand back from it invites opprobrium. But, in following a valuation insensitive strategy, momentum investors contradict the experience of history and the predictive power of valuation. Chasing over valuation because the majority of investors are doing the same thing condemns that majority to a rude awakening and, more importantly, poor future returns.
It is for this reason that I stick religiously to valuation discipline. It is the only way, in the long term, to insulate investors from permanent capital loss and importantly, to position them to benefit from attractive long-term returns. If you accept, as I do, that valuation discipline should be the foundation of a long-term investment strategy, it is incumbent on a fund manager that pursues such a strategy to explain clearly how valuation is judged. In this, again, I follow what I believe to be a common-sense approach.
The success or failure of most businesses pivots on the things that the business can control (for example the actions of management) and the things that it cannot, for example, the behaviour of the economy in which the business operates, the regulatory landscape and the actions of competitors. It is for these reasons I believe a comprehensive view on valuation can only follow the analysis of a business alongside the economic environment in which it operates. In essence, the micro and the macro.
Taken one step further, it should then become clear why an investment process, founded on a valuation discipline and drawing on corporate and macroeconomic analysis, will drive a fund manager towards certain stocks and away from others.
For example, if a business’s future success (as measured by its earnings) requires a level of economic activity that my analysis says is not going to be achieved then, by definition, its valuation is not going to look as appealing to me as it might to another investor who takes a different view. In essence, this is not a scientific process founded on absolute laws. It is a process which has subjective judgements about the future embedded within it. This is difficult, requiring extensive analysis and due diligence but there is no escape from it if one truly believes in a valuation discipline as I do.
There is one other point to make about valuation. It is not one dimensional. The chart above uses the price / earnings ratio (PE) as the proxy for valuation. This may be imperfect, but it is consistently so over time. I am content it is a good proxy for the valuation of public companies and furthermore data on PE ratios goes back a long time.
Having said that though, companies can be judged to be undervalued even when they don’t have any earnings, cash flows or pay dividends. We know this from everyday life, of course, (many things have intrinsic value that don’t deliver a cash return) but it requires a bit of explanation in a financial market setting. Let me give you a real-life example to illustrate the point.
Valuation case studies: Amazon and Inivata
One of the biggest companies in the world today, Amazon, grew rapidly over a twenty-year period following its IPO in 1997, but it was loss-making for several years and only modestly profitable until relatively recently. Nevertheless, it would be hard to argue that it wasn’t an undervalued asset through the early part of this history.
Another example would be a company that we have owned in the Woodford Patient Capital Trust (WPCT) portfolio for about three years. It is called Inivata. It has developed a technology (called liquid biopsy) which we believe will help to transform healthcare and especially cancer treatment in the years ahead. It is a technology, like so many others, that will disrupt incumbents but will also deliver better patient outcomes via quicker, cheaper, less painful and more accurate diagnoses. It is a business we have helped to nurture through its development phase, and it is now commercialising, having recently received a positive reimbursement decision from Medicare for its initial test, a non-trivial task.
Inivata is now clearly on the road to commercialisation and we have high hopes for it. But, is it an undervalued asset, is it cheap? It has as yet, no sales, profits or earnings and it pays no dividends. In our view, however, it is profoundly undervalued. We made this judgement through our own analysis of the business’s potential but, by way of proxy, we can compare it with its closest peer in the US, a company called Guardant which has also developed a liquid biopsy test.
Guardant’s test was approved about nine months ago and is further ahead than Inivata’s but we believe the Guardant test is less sensitive than Inivata’s. Either way, it is a directly comparable business. Interestingly, Guardant has a market value of almost $6bn (it is quoted on Nasdaq). Inivata, even after a recent valuation uplift, is valued at only $170m (it is held in our unquoted portfolio). In our judgement, this business is incredibly cheap, but it doesn’t fit in the conventional analytical model that looks at valuation through a PE and dividend yield lens.
In this regard, Inivata is similar to many of the smaller businesses we own in the Woodford portfolios. Businesses that we have analysed extensively and in which we have huge confidence but about which, more broadly, there is a lack of knowledge and an abundance of scepticism. I have to do a better job at explaining why these stocks are in our portfolios, how they fit our valuation criteria and why we believe they will deliver very attractive returns to our investors.
Early-stage exposure
On the subject of early-stage businesses, it is clear there is a degree of nervousness about them within our investor base. My colleagues and I need to do more to educate and inform our investors about what these businesses do, why we own them and why we think they will deliver exceptional returns (and why we think they are so undervalued).
As we said on 1 March, our long-term intention is to not have any exposure to unquoted holdings in WEIF. Instead, the fund’s exposure to the unquoted asset class will come through listed investment vehicles, such as WPCT. This process is already underway and the fund’s exposure to unquoted securities (including those listed on less well-known exchanges where there is little or no trading activity) will decline over the remainder of this year to below 10%.
In some respects, this will naturally decline because many of the largest, less liquid holdings in WEIF are in businesses that we have been nurturing for many years (for example, I first invested in Oxford Nanopore almost a decade ago), and some of these businesses are maturing into companies that are ready for a full stock market listing. Some others are approaching inflection points where new investors are coming onto the register (for example, large overseas institutional investors) and these afford liquidity opportunities that we will be able to take advantage of where appropriate. It is also the case that some of the smaller early-stage companies in the fund have developed so quickly that they will, over the next few months, be launching full IPO processes (typically on Nasdaq).
The combination of all these carefully managed processes will mean that beyond this immediate period, WEIF’s exposure to these less liquid holdings will reduce further to significantly below 10% and, over time, to zero. Of course, my interest in these businesses will continue for as long as they remain undervalued, and WEIF investors will be able to benefit from the continued growth in many of them via their full market listings and through WEIF’s direct holding in WPCT.
Outlook
Undoubtedly, the past three years have been difficult for our clients. Ultimately, the criticism I receive is driven by performance. Although I have experienced some company-specific disappointments, the fund has underperformed primarily because my valuation strategy has been completely out of step with a momentum-driven market.
As I said earlier, financial markets can for extended periods become detached from valuation fundamentals and whilst they do, fund managers like me appear incapable of delivering good outcomes. However, I hope I have demonstrated to you in this note that, in the end, valuation is what drives share prices and returns in the long run and that is why I remain resolutely focused on my strategy. I know the valuation disciplines deployed in everything I do professionally, and which guide the construction of the portfolios, will deliver the returns investors expect over the medium and long term.
To conclude this investment update, here is a brief outline of what I think will happen in markets over the immediate future and on towards the end of 2019. In the very short term, I believe there will be some important events which may catalyse a shift in broader investment behaviour not just with respect to the UK equity market but in markets across the world.
Although clarity on the interminable Brexit issue may still seem frustratingly distant, I believe that the odds of a softer Brexit have increased substantially as a result of the paralysis in Westminster. A no deal Brexit is now, in my opinion, extremely unlikely. I continue to believe that resolution will ultimately arrive through Theresa May’s deal being approved by Parliament (less likely) or a softer Brexit outcome (more likely) involving some form of long-term and close relationship with the EU.
If Brexit pans out as I believe, we will see a long overdue and significant rally in sterling – and this will have a meaningful impact on the UK stock market. It should at last liberate investors to start to acknowledge the underlying robust performance of the UK economy (last month we saw yet another series of strong data from the labour market and better-than-expected strong retail sales) and the profound undervaluation of companies exposed to the UK economy. At the same time these developments will also prompt the market to start to address the significant earnings and valuation risks in parts of the index where investors have significantly increased exposure over the last two years.
As far as the rest of the world is concerned, there are some very significant issues which investors should be paying attention to but aren’t, probably because the prospect of a US-China trade deal has got global investors very excited. From here, on that issue, there can only be disappointment. But, more importantly for global equities, slower growth now is the major challenge.
I have been saying for some time now that the world economy would slow and that this will be felt most acutely in Europe, emerging economies and in China. There is evidence that this slowing will continue in 2019. And because the US economy will also grow more slowly this year (under the weight of less fiscal stimulus and the lagged effects of last year’s excessive monetary tightening) global growth will slow further in the months ahead.
This, in turn, will quite obviously raise earnings risk against a backdrop of excessive valuation in markets, a potentially dangerous combination. A further headwind for markets, as we approach the summer is a significant deterioration in global US dollar liquidity, which may be the catalyst for a much less benign market environment than that which we have witnessed in the first four months of the year.
In summary, the comfortable consensus view that prevails in equity markets globally is about to be challenged by the issues highlighted in this portfolio update. The rest of the year is going to be very interesting and 2020 maybe even more so.
I am an investor from launch in Patient Capital and Income Focus, and yes it has been a tough period. The portfolio update on the income fund is very informative.
I have no doubt in Neil’s ability to understand the business case for the investments in early stage companies and would not have the cheek to challenge this. I would however suggest what Neil needs to explain better is how his team understands the fundamental science behind the business concerned. Proton Partners is a company which is not difficult to understand. The technology is established outside UK and is widely used. The only issue is will the UK medical community embrace the technology at a level where a profit can be made. Neil’s Biotechnology holdings are a different matter. Ultimately a companies technology may not work as shown by the clinical failure at Prothena. That is life and why drugs cost $1billion to develop as so many candidates fail. So Neil how do you judge the quality of the science behind your early stage investments because if that is wrong the company will go nowhere. Not everyone will succeed, but how do you select the most likely particularly independent verification of potential. The company scientists obviously have to be the cheerleaders for their technology!
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Mitchell Fraser-JonesModerator
13 May 2019 at 11:00 am
Hi Graham,
Thanks for the feedback. We do provide an investment case summary for many important portfolio holdings but, by definition, these can’t provide an enormous amount of detail on the significant amount of background work (both pre-investment and as a business develops) the team undertakes to understand the factors that will ultimately have a bearing on the probability of success of any investment opportunity. Perhaps this is something we can explore in greater detail in future articles.
Kind regards
Mitch
I think one thing that concerns investors is that Neil’s views on the resilience of the UK economy have been correct so far – unemployment is very low and GDP growth has been relatively good. The concern stems from the underperformance of the fund holdings despite being correct about the macro environment for them, especially as spending by the government, companies and households has exceeded income for several quarters (i.e. has been funded by adding to debt), thereby potentially impacting the ability to spend in the future when interest rates rise (as Mr Carney has indicated they will). Or will we finally get rapidly rising wages that give consumers the confidence to spend and borrow even more?
Another potential concern could be the cycle for unemployment. Whilst lower net migration post-Brexit should keep employment levels high, history tends to suggest that low unemployment is a cyclical factor and therefore more likely to reverse at some point than remain continually low (assuming economic cycles still exist). This might be a glass half empty view but, from an investors point of view, the best time to invest (and find value in under-priced assets) is probably when unemployment is high but with the prospect for improvement. Is there not a risk that we are currently at the opposite end of that cycle?
Hi Richard,
Thanks for your observations. You are right to point out that there is a contradiction in what we are now hearing from the Bank of England about the probability of interest rate hikes in the not-too-distant future, as opposed to the popular prevailing narrative for much of the last three years, which has suggested that the UK economy is perilously close to recession.
This is what Neil is referring to when he says, “financial markets can for extended periods become detached from valuation fundamentals” – the stock market has reflected the popular narrative, whereas the fundamentals of the UK economy have increasingly reflected something very different and much more positive. Neil has made a very insightful call on the strength and resilience of the UK economy but the funds have not yet been rewarded for this part of the strategy. The word “yet” is, we believe, a critically important component of that statement.
Kind regards
Mitch
I am also a long-term (and long-suffering) investor in the Patient Capital Trust. I wonder if you could help me understand the recent fall in NAV on May 9 by 3.2% from 95.47 to 92.41 without an equivalent drop in the prices of quoted securities. There has been no official comment on this significant revaluation. More worryingly, the revaluation was preceded by two days of significant share price drops of 2.1% and 2.3% respectively. The lack of information provided goes against the “openness and transparency” that the trust purports to maintain.
Regards
John Dalton
Hi John,
The decline in the net asset value of Woodford Patient Capital Trust to which you have referred is due to the write down in the valuation of an unquoted holding by the trust’s AIFMD, Link Fund Solutions. Although, as you point out, we have an open and transparent communications policy and a strong desire to let investors know what is happening within the portfolio, it isn’t always possible to provide immediate comment, or to be as open as we would like to be, for reasons of market sensitivity. This is one of those situations, and there isn’t any more we can say currently. We will update you and other investors on the matter as soon as we can.
Kind regards
Mitch
Hi, I personally hold a substantial amount of the Woodford Equity Income Fund in my Pension fund. The value is down as of today valuations iro 14% from early September 2018. I know the markets took a tumble last Autumn/Winter, but most other funds seem to have got a decent bounce back from that period. My concern is that the fund will continue to be having a large amount of redemptions and this is a difficult one to handle if you are having to sell out of your most liquid holdings and of course the investments will likely have been ones that you would have rather held longer to get some value back. Can you give a long term supporter any crumbs of hope of a turnaround? Over the years I have invested in Neil funds with Invesco and then moved a very substantial amount to Woodford, however, at present all the profit that I had ever made with Neil on smaller amounts whilst growing funds has now been wiped out, plus substantially more since I have moved larger amounts over to invest in 2015 in my Pension pot. I was hoping for high single digit returns which always used to be the target!
Hi William,
Thanks for your comment. When dealing with a period of redemptions, a fund manager is obviously forced to sell something. But that is very different to being a forced seller of anything.
As Neil’s article above explains, his disciplined valuation-oriented approach guides all of his investment activity, whether his funds are in inflow or outflow. Neil has accessed liquidity across the market cap spectrum (selling some large caps as well as some smaller companies), in order to maintain the shape of the portfolio towards the most attractive long-term opportunities that he sees.
I would hope we can offer you more than a few crumbs of hope and reassurance. As Neil says above, “the inevitability of a correction in overvaluation is certain. The timing of that correction, unfortunately, is not.” It follows that we believe the same applies to undervaluation. As a long-term supporter, we genuinely hope you have enough patience to ultimately benefit from this.
Neil’s aim continues to be to deliver a high single-digit annualised long-term return from the funds. The longer the market environment suppresses the delivery of that return in the near term, the more likely it is, in our view, that future long-term returns can comfortably exceed that expectation.
Kind regards
Mitch
Another day of quality performance by the EIF!. Does Neil think this might be below £1 per unit very soon?
Hi Peter,
That is not a question we can answer because it depends on so many short-term variables which are impossible to predict.
Kind regards
Mitch
I have invested in equity income fund which is 20 % below the price I invested. I understand Neil’s explanation about valuation and fully support that.
One thing I am not clear is the approach of not sticking with and sometimes completely selling some large caps within short time frames.
Hi Sachin,
Thanks for your support. We have a disciplined, long-term investment approach and all of Neil’s investment decisions are taken with a three-to-five year perspective in mind. Occasionally, market movements or changes to the investment case may mean that our investment view changes over a shorter time period than this, and we will of course respond to such a circumstance with discipline, even if it appears to contradict the long-term nature of our approach.
Recently, the market opportunity set has been evolving very rapidly and, as a result, there have been a few instances where we have bought and sold positions in a relatively short period of time. Not all of them have been in large caps.
Nevertheless, the turnover of the portfolio remains characteristically low and consistent with the time horizons mentioned above. Turnover on the LF Woodford Equity Income Fund (calculated by taking the lesser of aggregate buys and sells, divided by average fund size) in the year to 31 March 2019, was 18.7%, reflecting an average holding period of more than five years.
Kind regards
Mitch
Another day of stellar performance, surely its time for more comforting words from Neil?