Woodford Equity Income - Waiting with Woodford

Kate Marshall | Mon 07 January 2019

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There are two parts to our fund analysis. We crunch numbers, lots of them. But they’re only half the story. We also think it’s important to meet fund managers face to face. It helps us to understand how their fund has been built and might perform in different conditions.

We recently met with Neil Woodford and his team to discuss performance of the LF Woodford Equity Income Fund and the investments he’s made for the future. So it’s a good time to update you on how the fund’s evolved and what we think about it.

It’s no secret that we’ve been long-term supporters of Woodford. But his funds have recently performed poorly, as shown below. It’s been an uncomfortable time to hold the fund and our own conviction has been tested.

LF Woodford Equity Income fund - performance since launch

Past performance isn’t a guide to the future. Source: Lipper 02/06/14 to 31/12/18

With this in mind you might be wondering why we have not removed the fund from the Wealth 50. It comes down to our belief that there’s a greater probability he’ll deliver attractive returns in the years to come than there is he’ll continue to perform poorly. Below I’ll review his investment style and explain why we think he can perform well in the future.

Investing against the herd

Woodford often invests against the herd. His funds can look very different from the wider stock market and the funds of his peers.

He identifies what he thinks are a company’s opportunities in years to come. By its very nature a value opportunity is one that is not currently recognised by the market, so as investors we have to be mentally prepared for periods where performance is weak.

You can see from the chart how aggressive Woodford’s been in shifting the sector allocation of his funds to fit his views.

Woodford Sector Allocation

Source: Hargreaves Lansdown 01/06/01 to 01/10/18. Figures may not add up to 100% due to rounding.

This chart shows how Neil Woodford has changed the sectors he’s invested in. It shows Invesco Perpetual High Income between October 2001 and October 2013. From October 2014 the chart shows investments made in the Woodford Equity Income fund.

As a result we expect his funds to go through extended periods of underperformance as well as outperformance. There will be times where his views are out of kilter with the market, and people question his judgment, as they do today. That’s part and parcel of being a contrarian investor.

We’re currently seeing one of these periods of underperformance. Let’s delve a little deeper into why.

The UK market is unloved by investors and fund managers alike. And concerns over the impact of Brexit have meant that sectors which rely on the UK economy have been particularly unpopular.

Woodford takes a different view. He thinks the prospects for the UK economy are far better than most believe. He told us he’s never seen such a big difference in value between stocks he considers cheap and the ones he thinks are expensive. He’s a contrarian investor so is naturally drawn to these businesses that are out of favour. As such he’s taken big sector positions to benefit from this view, with large investments in financial and industrial companies. He’s also invested heavily in the UK housebuilding sector and the shares of associated building suppliers.

So far these investments haven’t paid off. The uncertainty around Brexit has kept these sectors out of favour and their performance has been poor. Investments in companies such as Provident Financial, Capita and The AA have also been weak. This is why Woodford’s fund performed poorly over the past two years.

The fund’s future performance is likely to be heavily tied to the strength of the UK economy and how Brexit plays out. There are no guarantees but we think a soft Brexit or no Brexit at all will see the fund perform well. Just getting a solid conclusion to our future relationship with the EU could see an upturn in its fortunes. But in the event of a hard Brexit, and while the outcome continues to be uncertain, we think the fund will underperform.

This highlights the importance of having a diversified portfolio, spreading your investments amongst managers that invest differently. That way your portfolio’s not relying on the outcome of one or two factors that are hard to predict.

We’re in it for the long run

Woodford’s been included on the Wealth 50 list of our favourite funds since we created it in 2003.

Since then Woodford’s delivered a return of 234% while the FTSE All-Share Index has returned 183% (both with dividends re-invested). Of course, these figures are calculated based on the past and the future is likely to be different. Over his whole career he’s delivered a return significantly higher than the stock market, as shown below.

Neil Woodford's career track record

Past performance isn’t a guide to the future. Source: Hargreaves Lansdown 30/09/88 to 31/12/18

The LF Woodford Equity Income Fund launched in June 2014. The period before reflects his performance as manager of the Invesco Perpetual High Income fund.

Since we don’t know how the fund will perform in future we have to rely on the fund information we’ve gathered. We believe Woodford’s demonstrated the ability to get the majority of big economic calls right. And he’s proven to have the analytical skills to invest in the right sectors and companies to profit from these views.

He’s managed money through multiple market cycles, investor fads and unexpected events. He came close to losing his job in the late 1990s when he shunned internet stocks just before the big dotcom bust. Heading into the financial crisis, he stayed clear of banks. When he’s made big calls, he’s usually come out on top.

Of course, in future he might fail to get these big calls correct, or pick the right stocks, but we feel it’s simply too early to give up.

Where else is the fund invested?

Woodford has also increased his holdings of small and medium-sized companies, both of which are higher-risk than larger firms. In fact some of the companies he’s invested in are so small they’re not yet listed on the stock exchange.

These companies are highly innovative and are shaking up traditional industries – with this comes opportunity to take market share. His current focus includes healthcare companies working on ground-breaking therapies and treatments, as well as consumer and financial businesses using technology to pioneer new services. Woodford’s particularly bullish on the unlisted part of his portfolio. He sees a number of these businesses making good progress as they try and grow into successful companies. Time will tell.

What about income?

Smaller companies often re-invest their profits to help them grow, rather than pay them out as dividends, so the fund sacrifices some income upfront for the prospect of better growth over the long term. The current yield is 3.5% although this should not be taken as a reliable indication of future income.

The annual charge is taken from capital rather than income generated increasing the potential for the capital value to be eroded.

Rather than aim for a strict income target Woodford focuses on total return, combining a rising income and growth in your investment. While the fund doesn’t aim to prioritise generating a high income now, we think it can work well alongside other equity income funds as part of a diversified income portfolio. Or it could help maximise total returns over the long run.

What next?

It’s understandable that some investors are getting impatient with Woodford. We’ve been disappointed with recent performance ourselves. No manager outperforms every year though, so as investors we will have our conviction challenged. We back proven managers for the long-term and for longer than most. There’s lots of great managers to choose from but as part of a diversified portfolio, we still think Woodford has a place.

We could be wrong. If we are we’ll put our hands up. It might be tempting to change our opinion now to be rid of the current discomfort, but we don’t think it would be the right thing to do. We still think long-term investors will be rewarded.

Past performance is not a guide to the future. Source: Lipper IM to 31/12/2018. Where no data is shown, figures are not available.

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