Equity Income Fund update, November 2016

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Mitchell Fraser-Jones 16 December 2016 Est. reading: 5 min read

Home > Words > Insights > Equity Income Fund update, November 2016

November was an eventful month for financial markets, with the outcome of the US presidential election prompting significant intra-month volatility and an acceleration of the correction in bond markets.

At first glance, the response from global stock markets to Donald Trump’s victory looks surprisingly benign but headline index returns mask a considerable rotation between sectors. This stems from Trump’s pledge to cut taxes and increase infrastructure spending, which has been deemed positive for the parts of the market, such as construction companies and providers of raw materials, which are expected to benefit most from the new administration’s policies.

This has become known by some in markets as the ‘reflation trade’ and it has had a noticeable impact on price behaviour in the near term. We would caution against becoming too carried away by the prospect of a sustainable ‘reflation’, however. Making America great again is, in our view, going to be much more challenging than the market’s behaviour seems to imply. The US economy has been held back in recent years by structural issues, such as ageing demographics, weak productivity and excessive debt, that are just too significant to be tackled in a single political cycle. No president can have enough influence over these issues to make a material difference within four years, and we believe they will continue to exert as much of a profound deflationary impact on the US economy as they will on the UK economy and other developed economies around the world. In this sense, we believe that the market’s reaction to the election result has been based on misplaced optimism on growth and inflation.

Nevertheless, this market behaviour has created a challenging backdrop for the fund in recent weeks. During November, the fund delivered a negative return and marginally underperformed the broader UK stock market. Among the largest detractors of performance were our tobacco stocks, Imperial Brands and British American Tobacco, both proved vulnerable to the market’s current distaste for ‘bond proxies’ as bond yields headed higher. As we have said before, we don’t believe that this is an appropriate reaction to what has been happening in bond markets. We also remain convinced that tobacco stocks are extremely well-placed to deliver very attractive long-term returns to investors and added to both positions during the month.

Similarly, AstraZeneca and GlaxoSmithKline weakened further. There was no fundamental justification for these share price moves. Indeed, there was incrementally positive pipeline progress from both companies during the month and solid financial results from AstraZeneca.

On a more positive note, some of the portfolio’s strongest performers were its US pharmaceutical and biotechnology holdings. In part, these stocks were beneficiaries of the post-election relief rally in the US healthcare sector, but they were also helped by some positive fundamental developments.

For example, Prothena announced highly encouraging clinical data from an early-stage trial of PRX002, a potential treatment for Parkinson’s disease, which is being developed in collaboration with Roche. The PRX002 antibody appears to be safe and – crucially – it is able to penetrate into the brain. Currently available treatments only moderate the symptoms of the disease because, thus far, it hasn’t been possible to get drugs into the brain to modify the disease itself. This latest clinical data therefore offers the prospect of a major breakthrough in the struggle against a condition that affects millions worldwide as PRX002’s ability to reach the brain makes it a potentially disease-modifying therapy. Prothena now has three high potential assets under development, all of which are progressing through the pipeline rapidly and positively.

Another good performer was Theravance Biopharma, whose shares were helped by positive news on the Closed Triple combination therapy for patients with chronic obstructive pulmonary disease (COPD), which is being developed by GlaxoSmithKline and Innoviva. GlaxoSmithKline has filed a New Drug Application in the US for this therapy, marking an important milestone in its progress towards commercialisation. Recent developments bring forward the point at which Theravance will benefit from the royalty interest that it retains in the drug’s future sales. AbbVie and Alkermes also performed well.

Outside of the healthcare sector, other positive contributions came from the food business, Cranswick, which released very strong half-year results during the month and Legal & General on very little news.

Turning to portfolio activity, we reduced the portfolio’s exposure to non-life insurance company, Hiscox, which has performed very well over a long period of time. It is a great business, in our view, with attractive long-term growth prospects and a very strong, disciplined management team. Its shares now value these positive characteristics more appropriately, however, and so we recycled part of the position into other opportunities where valuations are a bit more appealing.

These included the commencement of a new position in life insurance business, Aviva. In some respects, the investment case for Aviva is similar to that for Legal & General as both companies have good management teams and very attractive valuations, particularly in terms of yield. Aviva, although broadly similar to Legal & General, has a portfolio of different growth drivers in savings and protection markets and we deemed it attractive enough to start building a modest position.

Elsewhere, we also took advantage of unjustified share price weakness to add to our positions in AstraZeneca, Drax, and Stobart at what we consider to be very attractive valuations. We also added a new unquoted position in the form of Accelerated Digital Ventures (ADV), a newly-formed business that aims to provide patient capital to young British digital businesses with significant growth potential.

In terms of outlook, we continue to believe that the portfolio is appropriately positioned for the current environment, based on what we expect to unfold in the years ahead. As such, we are absolutely confident that the fund is well-placed to deliver very attractive returns over the next three-to-five years. This has, however, been a challenging year for the fund’s performance. Given our fundamental long-term approach, we expect our investment strategy to underperform in certain market conditions but, at the same time, we appreciate that the experience can be discomforting for some investors. That is why we believe it is important to keep you informed of our progress and to help you understand the drivers of performance. Like last year, we are planning a ‘year in review’ piece in early January and we would like to use this as an opportunity to address any questions or concerns that you may have. We can’t promise to answer all questions, but if there is anything you would like us to cover in the New Year, please post your questions as comments below.

In the meantime, we would like to take this opportunity to wish you a Merry Christmas and a Happy New Year. Don’t forget to have a go at our Christmas Quiz – entries must be received by 20 December.

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  1. Are you still positive about Capita, who last time around were “reassuring” after a series of profit warnings? For a business with high visibility of forward earnings they now seem to have very low visibility of earnings problems. To me that smells like a management problem.

    1. I also would like more info on Capita.
      I might be mistaken but Neil’s past comments on the company seem to have vanished from the site

      1. Paul FarrowModerator 19 Dec 2016 at 2:13 pm

        Hi Tudor and Max,

        Thank you for your questions which we will feed into the update Neil plans to give investors early in the new year.

        Kind regards

        Paul

    2. nordy tawndish 16 Dec 2016 at 4:44 pm

      I share your concern about Capita. In my view the Fund should not hold the stock.
      Companies seeking to secure outsourced public authority work are in for a much leaner time as the bureaucrats gradually wake up to the fact that they can obtain better value . Consequently I have long expressed the view that Capita’s best days are behind it.

  2. What has happened at Capita to make them fall so far this year ? Is it a fundamentally well managed business or is there something behind the statements that is of concern ?

    1. Paul FarrowModerator 19 Dec 2016 at 2:17 pm

      Hi Steve,

      As we replied to Tudor and Max above, we will feed your question into the update Neil plans to give investors early in the new year.

      Kind regards,

      Paul

    2. 5 years of declining profits despite a rising revenue indicates that the company has been taking on business at thinner margins putting the finances at risk. This has had plenty of warning. Here are the profit numbers over 5 years from 2011 to 2016 :-

      £302M; £281M; £215M; £292M; £211M — I guess anyone who considered investing in the last two years would have looked at these numbers.

      The next obvious problem was a big increase in borrowings situation :-
      to £2.16BN — this is some over 10 times last years profits.

      With such declining business margins it looks to be a very high risk investment perhaps?

      LR

  3. What exposure does the fund (or the Patient Capital Trust) have to any potential investigations into excessive price increases in prescription drugs? If exposure exists what is being done to mitigate that?

    1. Hi David,
      We have focused our healthcare exposure (in both funds) towards truly innovative companies which we’ve always argued are not the focus of attention as far as pricing behaviour is concerned. We wrote about this last year here: https://woodfordfunds.com/words/blog/rewarding-innovation/.
      Kind regards,
      Mitch

  4. John Chipchase 16 Dec 2016 at 2:09 pm

    Hi Mitchell. Thanks for a very interesting report. I notice that one of your shares – Redde has reduced in price in the last couple of months which seems odd because the company appears to be performing well. I know that Neil is fond of Redde and does he expect their share price to improve in the new year? Regards John Chipchase

    1. Hi John,
      We would agree with you, the company does appear to be performing well but it is important to remember that sometimes share prices may rise and fall for reasons that have nothing to do with fundamentals. In the long run, fundamentals are all that matter for share prices, but over shorter time periods, they can be irrelevant.
      Whether or not Redde’s share price improves in the new year remains to be seen but we remain confident in the longer-term investment case.
      Kind regards
      Mitch

  5. I remember when the fund had around 100 companies. Now it has 120 or so. Is it starting the react like a tracker?

    1. Hi Anthony,
      This is something we will try and cover in the new year but in summary, most of the new holdings that we have added are not FTSE All Share index constituents so they haven’t brought the fund closer into line with the index. The fund continues to bear very little resemblance to the broader UK stock market – and indeed, behaves very differently to it as well. It is very actively managed – according to Bloomberg the fund’s active share (a measure of how different a fund’s portfolio is to its benchmark) is 86%, which suggests that a significant majority of the portfolio’s assets are invested in off-benchmark securities.
      Kind regards
      Mitch

  6. As an investor in the fund I am concerned about the negative impact of Brexit on the UK economy feeling that the outlook for several years after our exit are uncertain to say the least.My concerns are mirrored in what I see happening to the US economy-Trump is palpably no politician and will seek to run the US economy like one of his businesses(but on a bigger scale)Whether that approach will bring jobs and prosperity is open to question but obviously the American electorate have decided to take that risk.Similarly our electorate have decided to take the risks now being exposed by voting for Brexit.Am I right in thinking that the path ahead is strewn with uncertainty?

    1. Hi David,
      This is something that I’m sure we will deal with in greater detail early next year but we would be inclined to agree with you. Of course, the future is always uncertain but sometimes it may feel more uncertain than others. The prospect of Brexit and a Trump presidency aren’t necessarily the root causes of this uncertainty, however, but symptoms of the disappointing economic performance that has blighted the developed world since the financial crisis and a growing sense of frustration that the economic policies that have been pursued in this period have done very little to help the majority of voters.
      We invest with these long-term macroeconomic issues firmly in mind but you could argue that, at times in recent years, the market has been quite complacent about the big picture risks.
      Kind regards
      Mitch

  7. charles Paterson 16 Dec 2016 at 4:28 pm

    Every time I see you are increasing your positioning Tobacco companies my heart misses a beat as every pub I walk pass has more and more people sucking on fag substitutes!
    In the developed world tobacco use is falling and unless the third world are going to get richer and smoke more and more the health story will start to take hold. I don’t see a long term future for these investments.
    Iam happy to hear why I am wrong!

    1. It’s something over 1 billion people in the world freely choose to do and enjoy. In many developing countries they have more of a ethical problem with Alcohol.

      Tobacco companies are highly regulated (as they should be) and taxed now making the black market for cigarettes in the UK at a all time high. £2b in lost tax rev for HMRC last year as well as being up to 5 times a worst for your health according to the NHS. So if you want a ban on cigarettes or penalize Big Tobacco even more you’re going to find yourself doing more harm than good.

      Buying shares in a Tobacco company is not the same as giving them money to go out and do harm. Simply buying ownership that is outstanding.

      1. Charles PATERSON 16 Dec 2016 at 11:41 pm

        I am not interested in the moral argument .
        I bought into this fund for long term gain.
        I don’t see fags as the future.
        I want to be convinced by the fund manage that I am wrong! Otherwise I will consider my investment and evaluate its potential in the light that between 15 and 20 per cent is invested in shrinking industry.

        1. Hmm -are you all forgetting that tobacco firms also sell eCigs? That the big guns could buy out the eCig competitors?

    2. Hi Charles,

      The below is recycled (and slightly edited) from a reply to a comment last year but it remains very relevant.

      Analysts have been predicting the demise of the tobacco sector for years – decades in fact – and they have consistently been wrong. It is of course an industry which faces threats – some of them old (legislation) and some of them new (e-cigarettes). But it is an industry that is well-placed to continue to deal with these threats, in our view.

      The volume of e-cigarettes consumed globally is growing rapidly but it remains a small fraction of the overall tobacco market. Ultimately, as Anthony points out in reply, we view e-cigarettes as an opportunity rather than a threat to the tobacco industry. Although growth was initially led by new entrants, the incumbents have used their profits to acquire technology and invest in their own propositions.

      Tobacco consumption trends in the UK and the rest of the developed world have clearly been in decline for a long time. The industry has continued to deliver growth in cash flows, earnings and dividends. This has been achieved partly through an ongoing focus on cost, and partly because the decline in developed world tobacco consumption has been more than offset by the dynamics in developing markets where positive demographics and aspirations towards a western standard of living have driven strong growth in branded cigarette consumption. This growth looks well set to continue for many years.

      There are many other positive aspects to the tobacco industry investment case which I have not covered here (pricing power, improving US consumption dynamics and the prospect of further consolidation, for example) but I hope this provides some background to our attraction to specific companies within the sector.

      Kind regards
      Mitch

  8. Over the last month or so you mentioned that you would begin hedging the currency exposures of the fund. I am interested in your approach. Do you intend to:
    (1) hedge just the denomination of the assets you hold (i.e. buy GBP vs USD against the US denominated companies you own)
    (2) hedge the expected revenue flows of the companies you have holdings in (i.e. buy GBP vs USD against US revenue streams for companies like BAT)
    (3) hedge using some other process ?
    It would be helpful if you were not only transparent about the process used but also the amount you had executed.

    1. Hi Mark,
      That’s correct – basically it’s option 1, hedging substantially all of the currency exposures that exist within the portfolio as a result of our investment in overseas stocks.
      Kind regards
      Mitch

  9. Patrick Haughian 17 Dec 2016 at 10:06 am

    The reality is the fund,despite all the hype,is not performi

  10. There’s a very interesting “Special report” on the Woodford Equity Income Fund posted this week on Hargreaves Lansdown’s website.

    1. bernard curran 18 Dec 2016 at 10:53 am

      YES AND I READ THE REPORT AND LIKED WHAT I READ

  11. Once upon a time I held Invesco Perpetual High Income but lost faith in 2002 and sold out.
    I rue the day – had I held I would be sitting on 100s of % increase. Neil was ploughing his own furrow and playing the long game.
    I think he is doing the same again now – at least I hope so.
    I am glad I got in at launch and have added since too.
    I hold about half my investments in his fund. The other half are in my choices – I beg to hope I am diversified – but please note that Neil has publicly stated that all his own personal investments are held within his own fund – putting his money where his mouth is, so to speak.
    Just because the fund has chosen to give transparency dosn’t give us all license to be experts – and comments posted sure as hell are not going to influence Neil’s picks!
    I plan to have time in the market

  12. A little clarity over the situation with Capita is required. A couple of weeks before the second profit warning Neil stated that he had been in touch with management and was happy with the direction they were going and bought more shares.

    it does seem to have gone off the boil in the last two or three months, some of the top 10 have not been performing very well, appreciate this is a long-term but there seems to be a high degree of volatility with some of them. I echo all the thoughts of other posters as well about the number of investments in this fund now, and question the suitability of some of them.

    1. Jon AdairModerator 20 Dec 2016 at 8:17 am

      Thanks for your question Steve – we’ll feed your comment into the update Neil plans to give investors early in the new year.

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