Neil Woodford’s Test of Nerves

Is the great Neil Woodford of Invesco Perpetual heading for a Tony Dye moment? By resolutely refusing to chase the current junk-led stock market rally, and sticking instead to his defensive positioning, his hugely popular funds are falling further behind the benchmark indices. Year to date his flagship fund is 9% behind his sector peer group. 

In a recent interview with Citywire, he admitted that the pressure to conform, an ever present in all fund managers’ lives,  represents a major test of his nerve. Sticking to his deep value philosophy famously cost Tony Dye his job at the peak of the Internet bubble in 2000. But Woodford is – rightly in my opinion - sticking to his guns. Why right? Because his analysis to my mind looks all too well-founded, and there is almost certainly money now to be made by following it.

Because of the amount of money he manages – somewhere in the region of £20 billion in total – Woodford is inevitably forced to take big positions in some of the most liquid sectors of the market. To his credit he refuses to take the safety first route of simply hugging his benchmark. But it is a high risk strategy for someone with so much money to look after and such a high public profile.

Woodford’s three big calls this year are as follows:

1. Buying into big pharma
GlaxoSmithKline is now the largest holding in Woodford’s £8 billion Invesco Perpetual High Income fund, accounting for 8.3% of its value. AstraZeneca (8.2%) is his second largest bet. The fact that 28 brokers rate AstraZeneca as a 'hold' or worse, and only seven rate it as a buy, is no bad thing for a contrarian, but it underlines how out of step with the market he now is.

Astra Zeneca trades on a p/e ratio of 9.6, compared to the FTSE All Share's 17.16 times, and yields 4.95% compared to the All Share's 3.43%. The dividend is covered four times, while Glaxo's dividend is covered two times. The market is obsessed with the patent expiry problems both companies face, but are underestimating the organic growth that they retain.

2. Selling out of the oil majors
Woodford sold out his holdings in BP and Shell over the summer, trading them for increased holdings in the pharmaceutical companies. His argument is that the majors will struggle to hold their dividends next year,which may well be uncovered.

They aren’t generating enough cash both to maintain the dividend and to fund the capital expenditure programme they need to find new reserves. He still likes BG Group, which has great growth potential,  but given his negative view on future economic growth sees little upside in oil prices from their current level.

3. Spurning the banks
Woodford famously held no bank shares going into the financial crisis, a bold and anti-consensus stance that did his investors proud until this year. But he has stubbornly refused to buy back into the sector despite its strong rally from its start-of-year lows. While hedge fund managers such as Crispin Odey have ridden the surge in Barclays and other stocks with great success in 2009, Woodford’s reluctance has badly hurt the relative performance of his funds.

His argument is that the banks are still in crisis, and are only being kept afloat by Government support (which we all suspect is true). He won’t invest in companies whose financial status is so opaque and impossible for outsiders to analyse. He reckons there is still a fair chance that the Government will eventually come to the view that outright (if temporary) nationalisation of Lloyds and Royal Bank of Scotland is the least bad solution.

Although Woodford’s long term performance record remains unmatched, he is undoubtedly starting to feel the pressure. He told Citywire: “The biggest challenge for me, I suppose, is holding my nerve. As an observer of my industry for a very long period of time, most fund managers do hug an index and most do trade momentum. It frustrates me because I think we could and should do much better than that”.

“But it doesn’t surprise me that we’re like that, frankly, because when you go through what the market has been through for two years and what I’ve been through this year, it’s an incredibly uncomfortable place.  I’m afraid you are condemned by your process and what you believe in, and you have to stick to those as a fund manager or you’ve got nothing to hold on to. We believe in what we are doing. I believe what I’m doing”.

That’s fighting talk, but the bravado will, I am sure, prove to be fully justified. My experience, stretching back 30 years or so, is that the best fund managers don’t become useless just because their style of investment goes badly out of fashion. When they bounce back, they tend to bounce back very strongly indeed. And this is particularly true of value-oriented investors, which Woodford is.

As style analysis suggests that value has been left far behind growth in this year’s market rally, my conclusion is that Woodford's funds are now becoming very good bets for patient investors with a  medium-term horizon. They offer above market yields and are underpinned by strong cash generation. I have recently been adding to my holdings in his funds for that reason. Buying top rank fund managers when they are completely out of favour is one of the few surefire ways I know to make money out of active management, given the crippling burden of costs that they typically carry.

Read more...

Normality Returns - Up To A Point

Pinch yourself for a moment and it is possible to convince oneself that the financial markets have returned to normality after the drama of the global financial crisis. Libor, for example, has returned to more traditional levels after last year’s market seizure. Many stock markets are back to somewhere around fair value. The dollar has fallen back to a point where it is trading at around purchasing power parity against sterling and the euro.

Bond yields are rising towards a level that once more incorporates at least some expectation of future inflation. The yield curve is upward sloping. Investment bankers are doing well again, even if it is largely by dint of the fees from organising rescue rights issues for each other. After a year in which it has yo-yoed crazily, from a peak of $145 per barrel down to little over $40 a barrel, the oil price has returned to a level that once more appears to bear some relationship with the fundamental balance of supply and demand. Other commodities are following suit.

But these are still far from normal times, as even the most cursory glance at the news testifies. Although the banking system appears now to have been saved by the concerted efforts of governments and central bankers, the global economy is still going backwards, only at a slower rate than before.

Unemployment continues to rise, and the fallout from the ongoing economic slowdown is causing political turmoil in some of the worst affected countries. The risk of future banking setbacks remains acute as lending losses across a range of sectors, including corporate banking, private equity and commercial property, have still to be realised.

In commercial property, for example, the bill for excessive lending threatens to be impressively large, though it has yet to show up meaningfully in reported accounts. Chris Turner, the long-serving manager of the TR Property Trust, estimated last week that the value of UK commercial property assets has fallen by around 40% from its peak of £800 billion in 2007, and there is probably a further decline in values of 10%-15% to go before the cycle is through.

The debt that supports these £400 billion of UK assets amounts to £300 billion. It is going to take several years for the property business as a whole to work its way back to a healthy capital structure - “a long drawn out and hard refinancing road lasting perhaps five to seven years”, in Mr Turner’s words.

While the recovery in equity markets has been impressive, its resilience also remains suspect. The lopsided nature of the market’s recovery, led as it has been by the most cyclical stocks, many with poor financial characteristics, appears to owe more to kneejerk reactions than to considerations of fundamental value.

Many investors have been caught out by the speed and extent of the recovery from the lows of early March and to avoid being left behind have been buying the highest beta instruments they can find. News that the Coppock Indicator has flashed a buy signal may further excite this trend.

The comments made last week on this subject by Neil Woodford, Invesco Perpetual’s income fund manager, seemed to me to be apt. He sees parallels between today’s market conditions and the two-tier market that prevailed in the immediate aftermath of the 2000 technology bubble, when many high quality companies with solid earnings and healthy balance sheets were priced on yields and p/e ratios which, both then and in retrospect, appear ridiculous, especially when compared to those accorded to much flakier businesses.

“We’re in a similar sort of polarised market” today, Woodford thinks, the irony being that the companies that are best equipped to survive the choppy economic times that lie ahead are the very ones that the market currently refuses to favour.

The cyclical stocks that have done so well in the last three months have risen to astonishing levels, in his view, given that “there’s been no recovery in the economy, there’s been no increase in earnings, [and] there’s been no tangible sign of any improvement in profitability for many months now”. As it will be a long time before the economy begins to experience a sustained renewal of economic growth, he is surely right that it leaves a lot of risk in cyclical sectors, impressive though the current momentum behind that move has been.

Of course some will say that Mr Woodford is only talking his book, as his preference for defensive, higher quality stocks has for now left his funds’ performance trailing that of many of his peers. But that would be a dangerously short-sighted conclusion. The arguments for thinking that equities are now the asset class of choice for the medium term are strong.

One historic trend that has not yet returned to normal is the yield gap between equities and government bonds, which still clearly favours the former. As was noted here last week, making money out of Government bonds over the medium term at today’s yields looks extraordinarily difficult, although there will be opportunities to trade the market’s volatile perceptions of the inflation/deflation outlook. But the value is not necessarily where the market currently chooses to think it is.

Read more...

What Neil Woodford Expects in 2009

There is the customary common sense and wisdom in these comments from Neil Woodford, Invesco Perpetual's star fund manager, yesterday.

On the outlook for the UK

"I think the outlook for the UK and indeed the entire world economy deteriorated in the final months of 2008. There is significant further downside in the three interconnected factors of consumer spending, the housing market and economic growth. Taking house prices first, we have already seen a drop in average UK house prices of 20% from the peak level in August 2007. But house prices are still high in relation to average earnings, especially for first time buyers. In the early 1990s, the house/price earnings ratio fell very markedly, from almost five to just over three. Even if the fall is not as marked in the current phase of adjustment, it is quite possible that we will see another15%-20% drop in house prices nationally".

"The rise in house prices in the early part of this decade was fuelled by, and also facilitated, an increase in consumer borrowing. It too has risen to very high levels relative to earnings. Household balance sheets now need to be rebuilt, notably by reducing debt levels. But this is, by its very nature, likely to be a slow process. Lower house prices have already meant that home equity withdrawal (the process whereby households borrow against the equity in their homes), a previously strong support for consumer spending, has evaporated. As consumer spending is such a large component of UK GDP (60% in 2008) weaker consumer spending will inevitably impact GDP growth. The latest Treasury forecast of a 1% fall in UK GDP in 2009 looks far too optimistic. Furthermore, the recovery from that is unlikely to be a sharp, ‘V’ shaped one. With consumers and banks deleveraging and with the prospect of a very large government fiscal deficit, the recovery after 2009 is likely to be pretty anaemic".

On the prospects for equities

"With the sharp falls in the UK and global stockmarket in late 2008, the UK market seems to be discounting an outlook which is at least as bad as that which I foresee. Overall UK equity market indices are now lower than ten years ago and I think there are good grounds for thinking the overall market has bottomed. But, as always, it is important to look at individual stocks and sectors and at that level there is some very good value indeed. The best value lies in companies that will be able to get through this difficult period for the economy with rising earnings, cashflow and dividends, and where this prospect is not appropriately valued by the market. I would highlight sectors such as pharmaceuticals, utilities and tobacco".

I have nothing to add, as Charlies Munger likes to say.
Read more...