Equity Income Fund update, March 2017

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Mitchell Fraser-Jones 21 April 2017 Est. reading: 6 min read

In the middle of writing this month’s roundup, the Prime Minister has called a snap General Election. Before we get to the fund roundup, I took the opportunity to ask Neil for his view on this latest political development…

“Theresa May’s decision to take the UK electorate to the polls again in June looks very astute. I expect the Conservatives to win with an increased majority and, from that perspective, it looks like a no-brainer for May to capitalise on opposition weakness and secure a new five-year term in which to negotiate and deliver the UK’s exit from the European Union.

I’ve said before that I am now more optimistic about the outlook for the UK economy than the market consensus, which has become increasingly negative since the EU referendum last year. The snap election does nothing to change this view – in fact it is positive as it should give us, as investors in the UK economy, much greater clarity and stability on domestic monetary and fiscal policy over the years ahead.

Clearly, the election process will attract a lot of attention and generate a significant amount of column inches. From the perspective of financial markets, however, I don’t think it will prove to be as important as other elections – not in the near term at least. That is in part a function of the global nature of the UK stock market, but it is also because there is a reasonable amount of certainty around the outcome. The same cannot be said about other elections taking place elsewhere in Europe with, for example, the first round of the French elections just about to commence. There is very little certainty about the likely outcome of that contest and the possibility of another populist political surprise has the potential to make markets somewhat nervous in the weeks ahead.

In the UK, however, and with a longer-term time-frame in mind, I believe the prospect of a snap election removes much of the political risk that could otherwise have been present in the Brexit negotiations. I see a lengthy period of improving economic stability in the UK – one which is now much less likely to be derailed by politics.”

Neil Woodford, Head of Investments

Equity markets generally performed well in March in choppier and somewhat directionless conditions. With market participants seemingly unable to decide whether to retain faith in the ‘reflation trade’, sentiment swung swiftly between commodity stocks and exporters on the one hand and less cyclical parts of the market on the other.

In part, this may be explained by an observed split between positive forward-looking ‘soft’ data, such as surveys of business and consumer sentiment, and more sobering backward-looking ‘hard’ data, which evidences actual economic activity. For some time now, the soft data has been suggesting that a pick-up in economic growth lies just around the corner but the hard data has thus far failed to deliver the much hoped-for recovery. As a result, the market’s confidence in the reflation trade has started to wane but occasional positive macroeconomic data points are seized upon with renewed enthusiasm.

This flip-flopping has been reminiscent of the ‘risk-on / risk-off’ behaviour that characterised markets in the aftermath of the global financial crisis. In our view, it is indicative of a market that reflects a lack of conviction in the macroeconomic outlook. As was the case then, we have maintained strong conviction in our economic view, which is that the global environment will be remain challenging in the years ahead, with the deflationary forces of demographics, debt and weak productivity combining to hold back growth and inflation around the world. The funds have consistently been positioned with this view in mind.

The fund delivered a positive return in March and outperformed its benchmark, with much of the positive performance coming from healthcare holdings. The fund’s largest holding, AstraZeneca, performed well again in March, boosted by positive Phase III data from a trial of Lynparza as a potential treatment for ovarian cancer. The company also announced a strategic collaboration with Circassia, another portfolio holding, which has acquired the rights to develop and commercialise two respiratory products, Tudorza and Duaklir, in the US. We believe this deal is positive for both companies but, given the relative size of the companies, much more so for Circassia. It significantly strengthens the company’s strategy as a specialty biopharma business. The acquired assets look an excellent complement to Circassia’s existing respiratory portfolio and have the potential to accelerate the company’s overall commercial progress, despite its decision earlier in April to stop investing in its allergy portfolio after the results of its house dust mite trial showed a placebo effect similar to the one in the cat allergy trial last year.

Tobacco stocks British American Tobacco and Imperial Brands also delivered positive contributions to performance. Burford Capital also performed well following an impressive set of full year results, which were much stronger than expected and underscored just how well-positioned this business is in the fast-growing field of litigation finance.

On a less positive note, Allied Minds was the largest detractor from performance. The company announced a change in chief executive during the month which appeared to unsettle the market, as did the announcement earlier in April that it is discontinuing funding at seven subsidiaries, which has resulted in a further decline in its share price. It is our view that the market has overreacted to this announcement. We remain attracted to the Allied Minds investment case – indeed we remain strong supporters of the broader intellectual property commercialisation sector. The businesses we have backed have diverse portfolios of young, disruptive businesses with significant long-term potential.

The model works best, in our view, when small amounts of capital are deployed at a very early-stage across a wide range of businesses, and more capital is selectively deployed as and when those companies demonstrate successful progress against milestones. As is natural in this space, not all of them will fulfil their potential, and so it can become necessary to withdraw support and funding from certain businesses. These are obviously difficult decisions but it is an important discipline and sends a positive message to shareholders about a management team’s intent. We never believed that all of Allied Minds’ subsidiaries would succeed and we have built our positive investment case for the stock around the value that we see in a portfolio of more successful subsidiaries. By crystallising value in businesses that are not demonstrating the progress that had been hoped for, Allied Minds can focus more aggressively on the companies that are rapidly progressing towards their commercial goals and reallocate capital towards new ideas. In that respect, we believe the strategy is sensible and will help to accelerate the creation of long-term value for shareholders. We expect to hear positive news from these more promising businesses through the remainder of this year and into next.

Turning to portfolio activity, we participated in a public share offering by Prothena, which raised capital to further advance its pipeline. Although this is a long-term positive, the dilutive effect of the capital raising did put temporary pressure on its share price. Elsewhere, we added to the positions in Next and Horizon Discovery, and took part in a further funding round for Viamet, the unquoted drug discovery business that is focused on fungal infections.

Looking ahead, there are plenty of things that could happen that could unsettle equity markets in the near term. For example, as Neil says above, there are several important elections coming in Europe this year and another populist political surprise would have the potential to upset global equity markets. Although this would likely trigger volatility and some downside risk, in all likelihood, it would prove short-term and temporary – serving primarily to highlight the importance of a long-term view in the equity asset class. With that long-term view in mind, we are confident that there are some very attractive investment opportunities within the UK stock market and, by focusing the portfolio towards these undervalued opportunities, and avoiding areas where valuations are stretched, we are confident that the portfolio is well-positioned to deliver attractive returns in the years ahead.

LF Woodford Equity Income Fund
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