Equity Income Fund update, February 2017

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Mitchell Fraser-Jones 17 March 2017 Est. reading: 4 min read

February provided a more positive environment for the fund than we have seen in recent months. Although equity markets continue to trade near all-times highs, the shine appears to be coming off the ‘reflation trade’ as excitement over the outlook for growth in China and the US begins to give way to a more sober assessment of the global economic environment.

The change in market sentiment was particularly evident in the bond market, where yields declined noticeably as the month progressed. Meanwhile, within the equity market, leadership shifted from the resources sectors to more dependable areas such as healthcare and consumer goods. One reason for this was the earnings season – several large index constituents in the energy and finance sectors disappointed investors by failing to meet the elevated expectations that have become built into share prices in recent months. HSBC, Shell and BP were among the most prominent examples here. This was beneficial for the portfolio, which has no exposure to these companies.

The fund delivered a positive return in February, outperforming its benchmark. Some of the best performances came from our healthcare holdings, with AstraZeneca, GlaxoSmithKline and Prothena among the top contributors. Although AstraZeneca and GlaxoSmithKline both produced results that were slightly better than consensus expectations, their strong performance over the month probably owed more to the warmer market sentiment than any fundamental developments.

Another standout was Purplebricks. The company continues to attract an increasing number of customers in the UK and, with its launch in Australia progressing well, Purplebrick’s disruptive business model is beginning to demonstrate its international viability. Towards the end of the month, the company successfully raised further capital to enable it to expand its footprint into the US market, prompting a further significant positive reaction in its share price, which increased by more than 50% during the month.

Meanwhile, shares in Capita put in a more encouraging performance during February, following a series of profit warnings in 2016. We have said before that we were disappointed by events at Capita last year, which combined to undermine market confidence in the business and the credibility of management forecasts. We have spoken to management several times as these issues have unfolded, including a recent conversation with the new chairman who appears keen to ensure that the business takes appropriate steps to move on from last year’s challenges. In our view, Capita’s share price continues to profoundly undervalue the fundamental long-term attractions of the business. It will take time to rebuild credibility and value at the company but we believe the management changes announced earlier this month will mark an important step on that journey.

In terms of detractors from performance, Hvivo, an early-stage biotechnology company declined, following disappointing trial data from two phase IIa exploratory studies in asthma patients for PrEP-001, a potential, nasally-administered treatment for respiratory infections. Earlier studies have demonstrated success in reducing symptoms of cold and flu, and we are maintaining close contact with the company to assess how the asset will be developed from here.

Meanwhile, some of the portfolio’s intellectual property commercialisation businesses, such as IP Group, Malin and Allied Minds also detracted from performance despite an absence of news during the month.

In terms of portfolio activity, Arix Bioscience, an evergreen investor in early-stage businesses with a focus on life sciences, successfully made the transition from unquoted to quoted during the period, courtesy of its initial public offering (IPO). This resulted in a modest uplift to its valuation and an opportunity to add to the position.

We also participated in an equity offering by Mercia Technologies, the Midlands-based technology commercialisation business. This additional funding provides the company with further financial firepower to develop its exciting portfolio of companies across a range of high growth industries. Elsewhere, we added to several holdings in February, including Homeserve, Drax and Idex.

Looking forward, although it is encouraging to have seen a more rational market environment prevailing in recent weeks, it remains too early to sound the death knell on the reflation trade. The prospect of renewed excitement about a sustained improvement in the economic growth trajectories of some of the world’s key economies cannot be completely discounted in the near-term. However, the prospect of such an outcome actually materialising is even more remote. We have witnessed several iterations of the reflation trade over the course of the last eight years but, ultimately, they have all fizzled out when the hoped-for sustained and dramatic improvement in economic fundamentals has failed to arrive. We strongly believe that the same will happen this time and indeed, that fizzling process may have already started.

Regardless of what may or may not drive markets in the months ahead, it is important to remember that we are long-term investors, focused on valuations, the fundamentals of individual businesses and the broader economy. As such, we believe the portfolio is appropriately positioned and capable of delivering very attractive returns in 2017 and beyond.

LF Woodford Equity Income Fund
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