Has Neil Woodford Lost His Mojo?
Neil Woodford is a superstar fund manager. In 2013 he was awarded a CBE for services to the Economy. He has dedicated his life to achieving the best possible outcome for his funds and his investors. If you had put £1,000 into the Invesco Perpetual High Income fund in 1988 when he started managing the fund, then sold when he left in 2014 your investment would have increased 25-fold with a dazzling average annual return of 13%.
Woodford is a value investor from the same fold as Warren Buffett and Benjamin Graham, and is often contrarian, running against the herd. He avoided banks during the pre-financial-crisis bubble and avoided tech during the tech bubble. Now he is buying UK-focussed stocks that have sold off due to Brexit concerns. Right or wrong, he has a well-reasoned view and he acts on it.
Woodford is one of the best fund managers this country has produced.
So, what went wrong?
2017: Neil Woodford's Annus Horribilis
Woodford set up his own fund management company in 2014 and has since hoovered up a mountain of cash spurred by his reputation and cheerleading from financial media. At launch Woodford Equity Income raised an amazing £1.6 billion, Patient Capital Investment Trust raised £800 million and Woodford Income Focus £553 million. His funds were always in the "most bought" and "most popular" lists. Everything seemed to be going well. Then in the summer 2017 there was the first of a string of unfortunate events.
- July: Astrazeneca shares, his largest holding making up 8% of his portfolio at that time, plunged after its cancer drug failed a clinical drug trial.
- August: Provident Financial shares plunged over 60% after it revealed that its consumer credit division would make a loss and that the Financial Conduct Authority was investigating that division. Then another of Woodford's stocks, the AA group, fired its executive Chairman Bob Mackenzie for "gross misconduct".
- October: Jupiter Asset Management pulled out of Woodford Equity Income. This was a blow to Woodford's credibility because this demonstrated a lack of trust from a large institutional investor which had been a long-term supporter. In 2015 Jupiter had £900 million invested with Woodford, so Jupiter's lack of faith has been a very significant financial blow for his company.
- November: Fund management companies Aviva and Architas dropped Woodford due to a combination of factors. Architas said it wanted less UK exposure, presumably because it is less upbeat about the prospects for UK market than Woodford. Secondly it disliked Woodford's significant exposure to sectors such as finance and healthcare.
A company in the Woodford Patient Capital portfolio that has failed to prosper is Vernalis, a small UK healthcare company. In March 2016 Woodford was fairly upbeat about the company's prospects and the shares enjoyed a brief rally:
"...our holding in Vernalis performed well, having received FDA approval for the first of its extended release cough cold products, Tuzistra, in April 2015, shortly after the position was purchased. Investors continue to significantly undervalue the potential of Vernalis' cough cold franchise, in our view. It has four further products in development, alongside a portfolio of central nervous system and oncology programmes currently in the clinic.".
However, after peaking in September 2016 at 86 pence the stock market has disagreed with the fundamental analysis by Woodford and the share price has fallen by 90% at the time of writing in December 2017 to less than 10 pence.
Nobody could have forecast that the chief executive of AA would develop a mental illness, or that the clinical trial of a lung cancer drug would fail. Maybe the analysts at Woodford should have reevaluated their investment in Provident Financial after the first profit warning in June. However, these setbacks are to be expected given Neil Woodford's investment style.
This is the risk of Neil Woodford's investment style: he takes large, concentrated bets and sometimes he will get it wrong. In 2017 he got it wrong a lot.
Neil Woodford's Investment Style
Woodford runs three funds. Two of them are share funds that generate dividend income and are benchmarked against the FTSE Allshare index. The third is structured as an investment trust, is more speculative and invests heavily in small, unlisted companies and has no benchmark.
Here is a brief description of the aim, investment restrictions and benchmark for each of the two funds and the investment trust:
Income Focus Fund
Aim: High level of income and capital growth. Income is the primary focus and this comes through dividends.
What It Invests In: Only invests in established companies listed on the stock market but headquartered anywhere in the world.
Benchmark: FTSE Allshare index (in blue below)
Equity Income Fund
Aim: High level of income and capital growth. Capital growth is more of a focus than it is for the Income Focus fund. This is inherently riskier as more money is invested in small, emerging companies without a proven track record and higher risk of failure and capital loss.
What It Invests In: Invests mainly in UK stock market listed companies but can also invest up to 10% of the fund in small, emerging companies which are not listed on the stock market.
Benchmark: FTSE Allshare index (in blue below)
Patient Capital Trust
Aim: Double-digit returns over the long-term driven completely by capital growth with no return from income. The trust invests in companies that are small with a high potential for growth. This means investors should expect a lot of short-term volatility.
What It Invests In: Up to 50% of the fund can be invested in small, emerging companies that are not listed on the stock market.
Benchmark: No benchmark (but I've compared versus FTSE Allshare like the other two funds and the FTSE Allshare is in blue).
Woodford relies on his investments in unlisted companies to generate large returns, so here's what we mean by "listed" and "unlisted" shares.
Listed and Unlisted Companies
What is a listed company? This means that a company is listed on a stock exchange and must satisfy certain quality criteria to do so. For example the London Stock Exchange says the following about being listed on its Main Exchange:
"A listing on the Main Market represents a badge of quality for every company listed and traded on it, and an aspiration for many companies worldwide."
Investors require certain information when they buy a share in a company. Listing rules force a company to make this information available in a standardised form. For example:
- Accounts: Investors want to see the company accounts so they can judge how profitable the company is, and these accounts must be published according to an international standard and must be audited by an independent accountant.
- Established: To limit risk some investors want to focus on established and well-funded companies. Listing rules for the London Stock Exchange require that a company is beyond a minimum size either in terms of the shares it will issue or its existing capital (minimum is £700,000 in shares or £200,000 for debt securities).
- Governance: Who is running the company? Are they qualified? Is there an independent board of directors that can hold the managers to account and ensure they are serving the interests of the shareholders? Will remuneration of the directors reflect performance of the company? Do shareholders get to vote on how the company is run?
- Shares: These should be freely transferable, with no restrictions. At least 25% of the company shares must be in the hands of the public. Shareholders must be treated fairly in the event of a takeover and be allowed to decide the merit of the takeover and the process must adhere to strict rules.
Why would a company submit itself to such scrutiny, restrictions and loss of control? Being listed on an exchange means that the company has easy access to more capital by issuing shares or bonds. If the company's management decide to expand the business by opening new stores they do not have to get a bank loan and have more, possibly cheaper, sources of funds.
Conversely, companies which are not listed may lack the desirable qualities of listed companies. This is why investing in non-listed companies requires an order of magnitude more research and due diligence. And as non-listed companies are often small the chance of business failure is much higher than larger, more established companies with a steady stream of revenue and dominance in their marketplace.
Neil Woodford's investment style changes. This is because the same style does not suit all environments. For example during a share market rally cyclical stocks that outperform during periods of economic growth will usually have earnings and share prices that beat defensive stocks. Cyclical stocks are companies that cater to our wants (e.g. luxury goods) while defensive stocks cater to our needs (e.g. food). In a boom we may splash out on fancy cars and clothes. In a recession we cut back on those luxuries but still have to eat. The stocks in Woodford's portfolios will therefore reflect whether he sees us tightening our belts or splashing out in the mid-term future.
What doesn't change is Woodford's approach. He always looks at valuations today in comparison to the potential a company has to grow in future. He and his team do a great deal of research beyond the financials of a company, including meeting the management, thinking about the competition, and thinking about the future health of the company's whole industry. He also forms a view on the future macroeconomic landscape. If the US or China is in deep recession that will impact share markets globally regardless of the individual merit of each stock. If inflation surges then companies that can control the price of their goods will be at an advantage. For example, pharmaceutical companies with the patent on key drugs can raise the price of those drugs without being undercut by their competition.
Woodford is a contrarian investor. If there's a standard market narrative, which you can usually pick up by listening to investment analysts on the radio or reading the financial press, Woodford will usually bet against it. He did this successfully during the dot com bubble, when everyone bought any company with the internet in its business plan, again in the lead-up to the financial crisis when he was wary of financial companies, and now he's doing it against Brexit as UK domestic stocks have been devalued due to the uncertainty about the eventual outcome of the UK leaving the EU. This doesn't win him friends until the consensus narrative eventually ends and the market shifts in his favour, as it has in the past. It remains to be seen whether his call on Brexit will also prove to be correct.
Conviction & risk
Once Woodford decides on a company he buys large amounts, even if he's investing in large companies. In order to produce returns above an index he deviates a long way from that index by focussing his portfolio in just his top picks. This is called concentration risk. If he's right and the stocks he chooses rally then he is lauded as a genius. However, if he's wrong about just a handful of his stocks this can seriously hurt his return, as happened in 2017.
When he started his new company Woodford set his fees low compared to the rest of the active fund industry. Active funds in the UK charge an average of 1.4% according to an Investment Association survey. That means that if you invest £10,000 you will pay the fund manager £140 per year. The ongoing fee of his two equity funds is roughly 0.7% which is half the industry average. The precise fee depends on how you buy Woodford funds and is complicated by the different share classes. You pay most if you buy directly from Woodford and receive A class shares. You will get an X class, C class or Z class share if you buy from a financial adviser or a fund platform such as Hargreaves Lansdown, Barclays Stockbrokers, Interactive Investor, Fidelity Personal Investing and Alliance Trust Savings.
The fees vary across share classes and you can find more detail on the Woodford website for the Income Focus Fund here, Equity Income Fund here, and Patient Capital Trust here, but for your convenience they are listed below:
- X class 1.5%
- C class 0.75%
- Z class 0.65%.
What's great is that Woodford breaks down the total cost of investing in the C class for the year to October 2017 (there's a brilliant infographic explaining these components in their blog here):
Fee (% of investment)
What Is It?
Woodford pays for analyst and economist research out of their own pocket
Due to price movement between quoted price and traded price, not getting rid of pesky staff
For things such as Stamp Duty Return Tax in the UK which is a tax on share purchases
Difference between buying and selling price of stocks transacted
Total Cost of Investing
Patient Capital has a completely different fee structure which is pretty radical because Woodford is sharing their risk of underperformance with their investors. You pay a basic ongoing charge of 0.17% per year but you pay no annual management fee. Instead you pay a performance fee as they say on their website:
"Woodford Investment Management will not receive a fee for managing this investment trust, unless we deliver a cumulative annual net asset value (NAV) return in excess of 10%. The ongoing charges cover the general administrative costs associated with running the trust."
The fund sets a "hurdle" at the beginning of each year which is a cumulative annual 10% return. The fund also has a "high water mark" which ratchets upward as the value of the fund increases. In order to get paid the fund has to beat both the hurdle and the high water mark and its fee will be 15% of the fund return above the higher of these two.
Performance in the year to October 31st 2017 was 6.18%. This was disappointing given the FTSE AllShare returned 9.3% during the same period, but a small consolation for investors in the trust was that they paid only 0.17% in ongoing costs.
Woodford Investment Management keeps investors up to date on how it sees markets and answers their questions. Even the difficult ones. My favourite part of their website is "Awkward Corner" where Woodford answers questions such as:
Woodford's big call at the moment is that the impact of Brexit on UK domestic shares will be much lower than people expect. This view is partly based on a report by Capital Economics which Woodford have published on their website. The choice of Capital Economics is significant because the managing director of the company is a strongly pro-Brexit economist called Roger Bootle who describes Brexit as the "Great Escape" and shrugs off the fact that half of UK exports go to Europe or that one third of those exports are part of EU supply chains that are both proximity and tariff-sensitive.
Woodford has eschewed the view of most economists that Brexit will reduce UK economic growth. These include institutions such as the London School of Economics, HM Treasury, the OECD, the Confederation of British Industry, the National Institute of Economic and Social Research and Oxford Economics. Instead Woodford decided to go with the alternative and contrarian narrative that UK domestic focussed stocks are now too cheap and that the impact of Brexit has reduced valuations too much such that they represent a bargain.
Fund buyer expectations are unrealistic
I think Woodford' fall from grace is unwarranted because investors have unrealistic expectations of what he, or any fund manager, can achieve. Let's lay out some facts to help us manage those expectations:
- Very few people can beat the market consistently. The overwhelming evidence from large studies of active managers shows that consistent outperformance is rare when fees are taken into account e.g. 74% of UK fund managers failed to beat their index over the last decade according to the Dow Jones S&P Index versus Active Report for Europe.
- Those who do beat their peers do so because of luck not skill (see the Dow Jones S&P Persistence Scorecard for US mutual fund managers). Of the 703 funds they tracked which fell in the top quarter ranked by performance in 2011, by 2012 only 31% remained in the top quarter, by 2013 only 4.7% remained, by 2014 just 1% and by 2015 a miniscule 0.28%. If skill drove outperformance it should persist. The fact it doesn't shows that outperformance was due to luck not skill.
- Past returns of active managers are a poor predictor of future performance. This makes it almost impossible to find one of the rare consistent generators of outperformance. Piling into the latest fund with strong returns or chasing fund management superstars won't work, as Woodford and the Persistence Scorecard demonstrate.
- To beat an index you must take a risk above that of buying the index. There's no such thing as riskless return. The risk taken by Woodford is concentration risk. Greater risk increases the possibility for upside but also increases downside risk. Sometimes this just won't work and by taking concentration risk you will lose out.
Let's take a look at the performance of Woodford's Equity Income fund versus the UK index with which it is most strongly correlated, the FTSE 250. While there was a long period of outperformance since 2014 this has disappeared in 2017 and now the fund is neck-and-neck with the FTSE 250. In other words investors would have been better off with a cheaper passive FTSE 250 tracker. These cost as little as 0.1% per year, one seventh the cost of Woodford's funds. So if you want to take a contrarian view on the UK post-Brexit a cheap way of doing so is to buy a FTSE 250 tracker. Think of this as Woodford-Lite.
Ultimately the blame for underperformance has to rest with Woodford. One could put his poor stock picks such as AA and Astrazeneca down to bad luck. But rather than expecting him to outperform year-on-year every year we should instead manage our expectations. Investment mojo means outperformance over decades, so it's impossible to tell whether he has lost his mojo even four years after the launch of his company. In ten years, when he is 67 years old, we should have a better idea. He has certainly made some bold, contrarian calls that turned out to be right, but his Brexit gamble may go badly wrong if the outcome is actually worse than that priced into markets.
However, the four facts above certainly stack the odds against him keeping his record of outperformance. The shocking truth may be that neither Woodford nor any other fund manager had a mojo in the first place.