Equity Income Fund update, October 2016

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Mitchell Fraser-Jones 17 November 2016 Est. reading: 5 min read

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

October was a challenging month for the fund, with concerns about the prospect of a Clinton victory in the US presidential elections weighing negatively on sentiment towards health care stocks. At the same time, the month saw a significant rotation into parts of the market to which the fund is not exposed, including banks and commodity-based stocks. This environment saw the fund’s net asset value decline modestly, even though the FTSE All Share index posted a small positive return.

Unsurprisingly, given the negative sentiment, the fund’s pharmaceutical and biotechnology holdings were among the main detractors from performance. These included AstraZeneca whose shares fell towards the end of the month after adverse effects related to bleeding prompted the suspension of patient enrolment for its late-stage trials for head and neck cancer treatments. The market seemed worried about the possible implications this could have for the highly anticipated Mystic trial, the results of which are expected to read-out in the first half of next year. We do not share the market’s concern however, as the treatments are for completely different types of cancer and it is unlikely that there is a valid read-across. We remain confident that AstraZeneca’s innovative drug pipeline is well-placed to create substantial long-term value and added to the holding towards the end of the month.

Elsewhere in the sector, GlaxoSmithKline saw its shares weaken despite releasing very strong third-quarter results that exceeded market expectations by a substantial margin. Theravance Biopharma also performed poorly with its shares declining in response to a further equity offering. In our view, this fundraising is a long-term positive for the business as it gives it more capital to further progress its rapidly developing pipeline. We recently met its management team for an update on the company’s progress and the news coming out of the business is even better than we had previously thought. We continue to view Theravance Biopharma’s long-term prospects as extremely attractive.

Alkermes, however, bucked the general weakness in biotech and saw its shares surge on some very positive clinical data from its FORWARD 5 trial for ALKS 5461 – the company’s potential blockbuster treatment for major depressive disorder. The success follows earlier trial disappointments that saw Alkermes’ market cap more than halve in January this year. Nevertheless, the company retained confidence in ALKS-5461 at the time and this latest data represents an important step towards the commercialisation of an asset that the market had all but written off.

Meanwhile, Burford Capital also made a notable contribution to performance. The company specialises in litigation finance and has a strong track record of backing the right legal cases. During the month, it announced that it had opened its own law firm, which will provide an important in-house resource that should enhance its long-term prospects even further. A further positive was Utilitywise, which reported strong full-year results, alleviating the market’s concerns about the gap between its earnings and cash flow, which the company is working hard to reduce.

Elsewhere in the portfolio, tobacco delivered mixed returns during the month, in response to British American Tobacco’s proposed deal to acquire the remainder of Reynolds American. This news was greeted by an immediate spike in Reynolds’ share price to an all-time high to reflect the terms of the deal. Shares in BAT weakened, however, despite the attractiveness of the proposal for its shareholders. This had more to do with the activities of risk arb funds and the market’s pre-occupation with resources and financials, than an adverse interpretation of the commercial characteristics of the deal. Our view is that this deal was inevitable and, although it has happened earlier than we thought, makes a lot of strategic and financial sense. We will be voting in favour of the transaction.

The positive share price reaction in Reynolds American gave us the opportunity to sell the remainder of the fund’s position in the company at a very attractive price. BAT already owns 42% of Reynolds, so we retain indirect exposure to the business. We added to the positions in BAT and Imperial Brands, with the proceeds of the Reynolds sale.

Elsewhere in terms of portfolio activity, Roche was sold from the portfolio in the ongoing fight for capital, and we increased positions in several companies including Capita, Provident Financial, Lancashire and Paypoint. We also introduced two new unquoted biotech companies: AMO Pharma, which is developing therapies for serious and debilitating orphan diseases and Precision Biopsy, which is developing an intelligent biopsy technology to aid cancer diagnosis and which we’ve held in the Woodford Patient Capital Trust for some time now.

The other important strategy development during the month concerns currency. The recent weakness in sterling has led us to consider at what level we should hedge the portfolio’s US dollar exposure. For some time, we have been anticipating sterling weakness and broadly, this played out as we expected following the Brexit vote. The portfolio has therefore benefited from being unhedged in the period since launch, but we now believe that the weakness in sterling has gone far enough and so hedges were introduced against all remaining foreign currency exposures towards the end of the month. As with all investment decisions, this reflects a long-term view – we have no insight into what will happen to sterling on a three-month view, but on a three-to-five-year view, we no longer expect further material weakness in the domestic currency.

Looking forward, the surprise result of the US presidential election has removed some of the clouds that were hanging over the health care sector from a market sentiment perspective. Fundamentally, we did not believe that a Clinton presidency would undermine the long-term investment case for health care but the Trump victory has certainly improved sentiment towards the sector. Longer-term, we remain convinced that there are structural growth drivers for the global health care industry and we have found some very attractive and genuinely innovative and disruptive companies in which to invest.

More broadly, we don’t believe that the outcome of the US election dramatically changes the outlook for the US economy. We don’t see recession as a likely scenario but nor are we getting too excited about the prospect of a dramatic improvement in US economic growth. The market has seized upon plans for an infrastructure-led fiscal stimulus as a reason to sell US Treasuries and buy sectors that would benefit from more government spending, but we think it would be wrong to get carried away with this prospect. At the margin, a Trump presidency probably does mean more spending on infrastructure but this needs to be seen in the context of an already highly constrained fiscal position and some elements of the Republican Party that will be very resistant to fiscal stimulus and/or tax cuts.

‘Campaign in poetry, govern in prose’, as the saying goes and whilst it’s difficult to describe anything that we heard in the run-up to the election as poetry, the reality of a Trump presidency will likely be more moderate than was suggested by the campaign. In other words, not a lot has changed as far as the outlook for the US economy is concerned, nor indeed for our view of the global economy.

At the margin, risks have increased but our conclusion so far, is that the equity market has over-reacted to the Trump election win. We remain happy with the shape of the portfolio and confident in the prospect of attractive long-term returns.

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  1. I would be interested in your view of the risks now involved in the Eurozone. We have had the problems with Greece, Spain, Ireland etc along with Italian banks over the last 5 or so years. Are we beginning to see a break up ? Or are Brexit and the election of Trump, are just more problems for them to contend with. How do you think the Euro will now perform and does this alter your view on the companies in the portfolio. Finally will a rising dollar create a Chinese debt crisis ?

    1. vangelis kabartinas 18 Nov 2016 at 9:53 am

      Being a greek, I see no problems in our economy for the near future.The market will explode if Mr.Kyriakos Mitsotakis wins the elections and will go 400 points up to 1000,from current 600.I also see no problems in UK,pound’s inability to stabilize to the upside is a temporary one.You are right about an imminent chinese debt crisis.China is looking for new trading partners basically in Asia and won’t have the same sales results as before.

      1. Thanks for the response. Are you saying that Greece will remain with the Euro ? It seems quite a few of my Greek, Italian friends whilst they admit there are structural problems with the economy, blame the single currency acting as a straight jacket effectively killing competitiveness and tourism. Will the pound become a safe haven again in that environment, especially with a sympathetic Trump administration ?

    2. Hi Jan (and Vangelis),

      There are plenty of political events coming up in Europe and lots of scope for more surprises. We are keeping a close eye on things and will keep you up-to-date with our thinking. It is indeed plausible that political unrest could prove to be an existential threat to the eurozone project but impossible to determine how and when that may play out. It is a risk though, and one that we are bearing in mind from an investment strategy perspective.

      Equally, it is very difficult to predict how these events may affect the euro – you might expect weakness but on the other hand, if it started to trade more like the old deutschmark, you might expect strength in the currency. That is why we’ve believed for some time that it was appropriate to hedge our euro exposure (until last month, that was the only currency that was hedged).

      As for the impact dollar strength may have on China – China already has a debt crisis but recent events may make it worse.

      Kind regards

      Mitch

      1. constance vd merwe 18 Nov 2016 at 11:41 pm

        Thanks Mitch. Have you removed the euro hedge then or are you sticking with it going forward?

        1. Hi Constance,
          We’re sticking with the euro hedge. All currency exposures in the fund are now hedged.
          Kind regards
          Mitch

    3. Read Wolfgang Munchau in Monday’s FT for a good synopsis of what might happen. If Renzi loses the referendum and calls an election as promised, it is alarming to note that ALL THREE opposition parties in Italy are calling for the country to exit the Euro. If this were to happen it is hard to see how the Euro could survive. Such a move would put enormous pressure on the remaining members and no doubt cause other economically weak states such as Greece and Portugal to depart.

  2. Thank you for the update.

    I am curious to know your current view on P2P and VSL, both of which have seen a relentless decrease in share price over a prolonged period now, and both of which trade at a very large and growing discount to their reported NAV.

    Are you still happy with the funds significant exposure to these companies?

    1. Matthew Pertici 17 Nov 2016 at 8:40 pm

      I recently bought into P2P at £8, £2 below it’s NAV, i think P2p and VSL have been oversold. Whilst they still have high risk compared to other forms of debt, you are getting a nice yield from them for composition. I though they were never worth the £10 a share, the share started at, because of the risk. But that’s just my personnel opinion.

      1. Thank you for your opinion, Matthew.
        What interests me is that in these updates and other blog articles we hear about the Woodford team taking opportunities to increase positions in companies where there is a belief that their share prices have become fundamentally undervalued. Given that the Equity Income Fund purchased P2P and VSL at a significantly higher share price than their current level, I would have expected further buying if the confidence in this type of debt fund was as high as it were before.
        I would therefore be very interested to hear the latest Woodford team view on the possible reasons for the poor share price performance and what now justifies the fund continuing to ‘hold’ these equities, as apposed to accumulating more or selling them.

    2. Hi Mr. Bradford,

      The size of the discount that has opened up between the share price and net asset value is disappointing but we don’t believe it is warranted. We are in dialogue with both companies and will of course continue to monitor the situation closely.

      Kind regards,

      Paul Lamacraft

  3. Thank you for this update. Interesting to see that you’ve sold Roche. I’m staying with them, in part because of their parnerships, e.g. with Prothena (WPCT, cf.) But that’s the reason for investing with a professional as well as doing a bit on one’s own…

    1. constance vd merwe 19 Nov 2016 at 10:27 am

      Mitch,

      I gather nothing fundamental changed relative to Roche and you are merely allocating capital to what you deem more promising opportunities.

      Nevertheless: could you briefly comment (beyond your previous remarks on the currency dynamics) on your investment thesis’s evolution and the principal business reasons underpinning the decision to relinquish such a long-standing large position?

      Thanks.

      1. Hi Constance,

        Good question. Currency dynamics did play their part (Roche has done much better in sterling terms than in Swiss franc terms) but there is very little else to say. Roche is still a great, attractively-valued business and we were reluctant to sell – you have to make some difficult calls in this business.

        Kind regards
        Mitch

        1. Constance vd Merwe 22 Nov 2016 at 6:23 pm

          I suspected as much – thanks Mitch!

  4. Dominic Morris 17 Nov 2016 at 9:43 pm

    Thank you. I greatly value your transparency and your translation of political risk into investment thinking. Agree with you on prospects for the Trump Presidency.

  5. Richard Umpleby 21 Nov 2016 at 3:19 pm

    How do you think the likelihood of Russia taking back the Baltic states will effect Europe, The Euro and China?

    1. As Lithuania, Estonia & Latvia are unlikely to join with Russia on a voluntary basis one can only assume that you’re implying force on the part of the Russians, in which case NATO might have a little something to say about that… “An attack on one is an attack on all”?

  6. It’s a little perplexing that in an earlier blog you refrained from investing in the commodities sector because you didn’t think that the resurgence in sentiment in the sector wasn’t sustainable, yet you continue to add to holdings in the pharma sector where there is next to no sentiment at all. The improved sentiment in commodities seems to be by nature sector wide, but in the pharma sector improved sentiment seems limited to the one company that has good news. Surely the first rule of investing is to be diverse.

    1. This is a very good point. Look at the share performance of BP and Shell over the last 12 months. They also, consistently, pay hefty dividends. The price of oil will continue to improve, so in my view why shouldn’t they be part of the portfolio. Investors are moving out of defensive stocks so pharma and tobacco are being hammered, again! You can’t help but feel Neil’s cautious approach is costing money.

      1. You have made a valid point about Royal Dutch Shell that has been paying the dividend consistently since second world war. The brent / crude oil price have resurged thereby improving the oil industries share price due to the fact that the OPEC and non-OPEC have finally agreed to shave the production down.

        Instead of relying on sentiment investing approach, two approaches I depend upon are contrarian and value investing. The share price of the BP and Royal Dutch Shell were at the bottom of the bedrock between December 2015 and January 2016 and it was too good to miss the opportunity.

        Yes, I will accept the dividend will be cut down at some point because it is not sustainability like Neil Woodford has been saying recently and the share prices have quite volatile but I reckon these stocks are good for a long term investment.

        For pharma sector, I have always wanted to add GSK stock in my existing holding but the share price at the moment appears to be a bit expensive, I will add it when it hovers below £13 which give me enough cushion to withstand its high volatile share price.

        1. NEVER SELL SHELL

      2. NEVER SELL SHELL

        1. NEVER SELL SHELL

          got it?

    2. Hi David,

      I think I can explain why you’re perplexed – we invest on the basis of fundamentals, not on the basis of sentiment. We do not believe that the resurgence in sentiment towards commodity-related sectors is sustainable because we do not believe it is justified by fundamentals. Similarly, we do not believe that the negative sentiment towards the pharma sector is justified by fundamentals. Much of what we are seeing in markets currently doesn’t seem to be underpinned by fundamentals – that has led to a challenging period of performance for the fund but we are absolutely confident that fundamentals will reassert themselves in the end, they are all that matter in the long run.

      Also, I’m not sure I agree that the first rule of investing is to be diverse. Diversification is important up to a point but not at any price. I would suggest that conviction and discipline are both more important than diversification.

      Kind regards
      Mitch

  7. With the poor performance of Northwest Bio and Woodford’s substantial holding, will the apparent sale of millions of Cognate shares and NASDAQ’s requirement of the most favor nation’s clause causing disposal of even more holdings of Linda Powers provide Woodford with a majority of shares allowing voting powers to vote against all underperforming board members and perhaps clean house and turn that investment around?

    Also, Woodford has been awaiting the results of an investigation. Has that not been concluded after over year?

    1. Let me simplify this run-on sentence:
      1) The most recent NWBO filing shows Cognate has many fewer shares.
      From the def14a:

      (10) Consists of (i) 13,684,294 shares of common stock and (ii) 11,557,929 shares of common stock underlying currently exercisable warrants. Linda Powers holds the voting and dispositive power over the shares held by Cognate BioServices, Inc.

      2) The NASDAQ remediation required 8 million share disposal. From August 8-K

      a) Cognate will return and the Company will cancel 8,052,092 restricted shares previously issued to Cognate under the most favored nation anti-dilution provisions of the Contracts, and the most favored nation provisions will be deleted from the Contracts;

      3) This should make Woodford the majority holder.

  8. John Buckeridge 05 Dec 2016 at 6:32 am

    Very disappointed with the results from the Equity Income Fund this year. i have a big investment in this fund and do wonder if Mr Woodford is spreading himself too thinly with Patient Capital and other future additional fund activities. I also don’t like unquoted investments as they present valuation difficulties, and I don’t like any overlap with patient capital type investments as this is not why I invested in this fund. I am also concerned by apparent lack of due diligence at NW Bio. I would appreciate some comments on the perfomance ytd as i am considering divesting.

    1. Hi John,

      We understand your disappointment – It has been a challenging year for the fund’s performance, particularly from a relative perspective, but market leadership has been extraordinarily narrow. Without the positive contribution from the big six resource companies (Shell, BP, Glencore, Rio Tinto, BHP Billiton and Anglo American), for example, the UK stock market’s return has been nowhere near as impressive as the headline index returns would suggest. We have missed out on those gains this year but we continue to believe that our long-term investment strategy (and, by implication, the long-term interests of our investors) will be best served without exposure to these parts of the market.

      It is fair to say, though, that the things that we have invested in have delivered a mixed performance this year. Some of this is justified by fundamentals, but much of it is not. And please do bear in mind that, in the context of our long-term investment approach, one year is quite a short period of time. We remain absolutely confident that the fund is well-placed to deliver very attractive long-term returns to its investors.

      We intend to bring you more content in the coming weeks on the drivers of recent performance, which we trust you will find reassuring.

      Kind regards
      Mitch

    2. John, You seem dissatisfied, and understandably, I suggest you may want to take your investment portfolio into your own hands. You could simplify your investments by just selecting 25 companies to invest in. The current approach of investing in 125 companies is akin to some kind of index, more like a scatter gun approach to investing. There is no way you can control your decisions on this number of companies.
      Many of the investments with less than a 10th of one per cent of the fund seem strange and will have very little effect on the portfolio. In addition I would look seriously at removing many of the very highly indebted companies — look at Capita (akin to Serco, and possibly Babcock next) for example and the destruction in value this has brought about. I personally would avoid banks and insurance companies, minimise commodity exposure and focus on those companies with strong brands and have high operating margins and high ROCE.

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