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.

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