Woodford Equity Income fund update

Woodford “always learns from his mistakes”

The fund has outperformed the broader market since launch but lagged in 2016. Woodford summarised the year by saying “much of what we saw in 2016 does not appear to be grounded in fundamentals. In the long run, fundamentals are all that matter for share prices, but over shorter periods, they can be overtaken by other drivers, such as sentiment and momentum. That appears to have been the case in 2016 – market leadership has become increasingly concentrated in a handful of stocks, most of them commodity-related.”

The markets ran away from healthcare – an area that Woodford has large exposure to – as it moved towards banks and resource sectors. Financials, excluding banks, also lagged, proving to be a significant headwind in 2016. Woodford admitted that macroeconomics has become more important over the last few years and he “should have read it better.”

Capita – a case study

The fund’s relative weakness does not come as a surprise given its defensive positioning and continued absence from parts of the market that drove the index higher in 2016. An overweight to mid and small-caps proved unhelpful, while a number of stock specific issues weighed on returns.

At the individual stock level, Capita, one of Woodford Equity Income’s largest holdings, was among the major laggards, making it difficult to ignore its share price weakness throughout 2016. But Woodford typically adopts a longer-term view and bought more shares in Capita after each of its two profit warnings issued last year.

Woodford says “the market completely over-reacted to Capita.” The group’s new chairman is ex-PWC, the accounting firm, which somewhat alleviates concerns about its accounts (PWC’s role in the Oscars’ Best Film fiasco notwithstanding!)

Woodford expects the company to carry on its disposal program, including sales of the asset services and specialist recruitment businesses, which will likely help rebuild the balance sheet. Having traded on a PE (price-earning ratio) of 20x in the past, the current valuation combined with its dividend is deemed attractive.

What does Woodford expect from 2017?

In 2017 Woodford believes the market is likely to perform very differently. According to him, Chinese growth is likely to slow, as the current debt burden is seen as unsustainable while the stimulus of 2016 is unlikely to be repeated. One unit of growth now requires six units of debt, with capital productivity slowing further. Despite a more recent reflationary environment, Woodford does not believe we are in a ‘reflationary boom’. The risk of deflation remains as a lower level of growth out of China and structurally lower demand is likely to put downward pressure on the commodities sector, with last year’s rally unlikely to carry on in the medium term.

Turning to the US, Woodford believes Trump is likely to struggle to carry out some of his pledges. "There is a world of difference between a Trump tweet and what goes ahead. He has alienated people in congress…it’ll be difficult for him to get what he promised done.” The Fed will not rush to raise rates, with Yellen wanting to see the details of the fiscal stimulus package and responding accordingly. More broadly, the issues in the global economy continue to revolve around debt, ageing demographics, deflation and a lack of productivity growth among other factors.

Overall, Woodford continues to be cautious on the medium-term outlook for the global economy.

The UK in 2017

Woodford admits being more bullish on the UK economy compared to his peers, expecting inflation to peak at 3%, and believes the Bank of England is unlikely to raise rates and is willing to see through higher inflation (and lower real wages) while supporting employment.

The UK stock market’s PE of about 15x this year’s anticipated earnings implies a real annualised total return of approximately 8% over the next 10 years, based on the historic data trend since 1974.

Portfolio positioning and exposure

The fund continues to have a bias to the healthcare sector, a ‘secular growth story’, focusing primarily on innovation within big pharma and disruptive growth in the biotechnology sub-sector. In Woodford’s blog, he writes, “there are several interlinked structural long-term growth drivers that lead us to expect consistent and sustainable growth for healthcare companies of many different shapes and sizes in the years ahead”.

Demographics is seen as the major factor. Woodford goes on to say that “despite the extraordinary commercial opportunity that lies ahead for the healthcare industry, valuations are attractive and have become increasingly so over the past eighteen months. In fact, on some measures, the sector hasn’t been as attractively valued as it is currently since the early 1990s. For many companies, current share prices imply negative terminal growth rates in the years ahead, which suggests an industry in decline. Our expectation is for long-term growth, so the current opportunity is significant in our view and we are confident that the portfolios are extremely well-positioned to capture the long-term potential”. Financials, excluding banks, constitutes a large exposure for the fund with a number of new holdings added more recently.

With the fund holding no banks (having been out of the sector for some time now), Woodford believes this area “finally looks more investible.” Following the global financial crisis, the banks in the US and the UK have now largely recapitalised and the recent pick up in lending signals they now have adequate capital requirements in place. Credit growth has been encouraging. The question remains whether they can continue to create value and grow their profits. Woodford caveated this by saying although his sentiment turned more positive, this does not necessarily mean he will be looking to enter the sector imminently.

The current positioning suggests the fund remains more domestically orientated compared to the broader index and the peer group, although there are a number of companies with existing and expanding global reach. Woodford spoke briefly about Purplebricks, the estate agency that has been held in the fund since 2014. The stock delivered strong returns and has encouraging future prospects. Purplebricks is currently looking to move into the US, where there’s an even bigger opportunity to disrupt the market, as estate agency fees are even higher there than they are in the UK.

Speak to us if you have any questions

We enjoyed hosting Neil Woodford at our offices and loved hearing about what he believes is in store for his fund in 2017 and beyond.

You can read more about Woodford Equity Income here. If you have any questions about the fund or your investments, give us a call on 020 7189 2400 or email us at best@bestinvest.co.uk and we’ll be in touch.

This article does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact one of our advisers.