Join our community of smart investors

Should you stick with LF Woodford Equity Income?

Neil Woodford's flagship fund has been underperforming, so should you ditch it?
April 4, 2019

Neil Woodford built up a very strong reputation as a UK equities manager over 30 years, most notably with his Invesco Perpetual Income (GB00BJ04HX60) and High Income (GB00BJ04HQ93) funds, which he ran until 2014. He has since launched his own asset management firm, Woodford Investment Management, and launched three funds. 

The company's first and largest fund, LF Woodford Equity Income (GB00BLRZQB71), got off to a good start and attracted billions from investors. But over the past three years it has not done so well, and has experienced substantial outflows and been removed from a number of broker buy lists. 

So should you join the exodus or hold your nerve and hopefully ride out this difficult? We set out the arguments for ditching and sticking with the fund. 

 

The sell case 

Mr Woodford has a long-term record of providing a growing income and capital growth above that of the FTSE All-Share index. And LF Woodford Equity Income performed well at first – over its first three years it returned 38 per cent versus 25 per cent for the FTSE All-Share index. But between 18 June 2017 and 26 March 2019 the fund fell 21 per cent, during which time the FTSE All-Share index rose 2.8 per cent. If you held the fund between its launch in June 2014 and 26 March 2019, you would have a return of 9 per cent – well behind the 29 per cent increase in the FTSE All-Share index over that period.

LF Woodford Equity Income’s strong performance over its first three years was driven by good stock selection. Significant holdings in British American Tobacco (BATS), Imperial Brands (IMB), AstraZeneca (AZN) and GlaxoSmithKline (GSK) boosted returns. Successful revaluations and listings of the fund’s unquoted holdings helped further, offsetting share price falls for Rolls-Royce (RR.) and BT (BT.A). These two companies were among the fund's top 10 holdings at launch, but Mr Woodford sold or reduced them over this period.

But by the end of June 2017 the stock composition of the fund had changed substantially and, following the referendum on leaving the European Union (EU), Mr Woodford shifted more of it into beaten-up UK stocks focused on the domestic economy, which he said had become too cheap to ignore. And he was not alone in doing this – many UK equity and value managers have allocated to what they consider to be UK value.

However, these companies are still unloved and domestic-facing UK stocks have underperformed UK stocks that derive more of their revenues from overseas. So this is a reason why LF Woodford Equity Income has underperformed. However, other funds with exposure to UK domestic stocks have not performed as badly. While LF Woodford Equity Income lost 21 per cent between June 2017 and the present, the Investment Association (IA) UK All Companies sector average return was 0.73 per cent and the IA UK Equity Income sector average was a 0.8 per cent fall over that period. MSCI United Kingdom Value index, meanwhile, rose 6.6 per cent during that time.

A number of LF Woodford Equity Income's holdings have had problems. These include Provident Financial (PFG), whose share price fell 75 per cent over 10 days in May 2017, at which time it accounted for nearly 6 per cent of the fund's assets. AA (AA.) fell 66 per cent over the nine months to April 2018 when it accounted for nearly 1 per cent of assets. Capita (CPI) accounted for 3.2 per cent of assets in September 2016 when it traded at 990p a share, and still accounted for 0.82 per cent at the end of September 2018 when it traded at between 120p and 160p, having fallen around 80 per cent. Imperial Brands, which used to make reliable returns, peaked at a share price of 4,130p in September 2016, when it accounted for 7.6 per cent of the fund's assets. Its share price had fallen 38 per cent by 31 January 2019, but it still accounted for 7 per cent of assets.

Although Mr Woodford’s style is out of favour, he has also made a number of bad investment choices. These include companies with flawed business models such as the AA and regulatory issues such as Provident Financial. And he holds companies whose returns are now being wiped out, such as Imperial Brands.

Professional investors such as long-term backer Jupiter Asset Management, and wealth managers AJ Bell and Charles Stanley, held on after the initial stock problems. But these firms eventually withdrew support on the back of poor performance. Mr Woodford took such a big position in Provident Financial that he couldn’t sell out quickly and Woodford Investment Management's funds overall still hold 23.6 per cent of it. It also suggests that Mr Woodford no longer manages risk as well as he used to.

Some commentators say that Mr Woodford has made poor decisions because at his own company he does not have as much support or as many people questioning his investment decisions as he did at Invesco Asset Management, where he built his strong historic record. 

It’s also worth remembering that LF Woodford Equity Income's asset allocation over its first three years, when it beat the market, was similar to the asset allocation of Mr Woodford's previous funds at Invesco. It’s since he started changing this strategy that the problems have emerged.

Mr Woodford argues that the number of stock-specific problems have been fewer in recent years than in his previous periods of bad performance between 2002 and 2003, and 2008 and 2009. However, these periods were bear markets, when his funds lost less than the FTSE All-Share index. These periods of outperformance are the foundation of his excellent long-term track record.

Breaking down how Mr Woodford built his track record shows this. Since the start of this century, Mr Woodford’s personal track record, which includes all the funds he has run, is superb. He has returned 258 per cent versus 37 per cent for the FTSE All-Share index. However, much of this is the compounded effect of significant outperformance of the index between 2000 and 2003 (see chart 1).

 

 

Mr Woodford’s significant outperformance was at the beginning of the century, when he avoided much of the tech bubble, and in 2008 when he avoided banks and made great returns by investing in tobacco and healthcare stocks.

Investors who bought funds run by Mr Woodford at any point after the 2003 bear market and still hold funds he runs today will have underperformed the FTSE All-Share index by anywhere between 25 and 85 percentage points.

LF Woodford Equity Income's performance would be even worse if Mr Woodford didn't hold unquoted smaller growth stocks alongside high-yielding, large and liquid stocks, such as Imperial Brands. By the three-year anniversary of the fund these accounted for nearly 12 per cent of its assets and at the end of January 2019 had contributed to about 40 per cent of its returns.

But LF Woodford Equity Income's assets under management fell from £10.1bn at the end of May 2017 to £4.7bn at the end of February 2019, and Mr Woodford has mainly met redemptions by selling the most liquid, listed holdings, in particular the ones closest to the share price targets he has set. However, this meant the unlisted holdings accounted for a larger percentage of the fund's assets than they used to, breaching regulatory rules that limit this type of security to 10 per cent of assets.

So to reduce the fund's exposure to them, Mr Woodford has sold some of its unlisted holdings to another fund he runs – Woodford Patient Capital Trust (WPCT) – in return for 9 per cent of its shares. LF Woodford Equity Income's holdings overall are now more liquid, but it still retains indirect exposure to these unlisted growth stocks. However, the transaction raises governance concerns: is this what is best for investors in both these funds, or is it just to manage these regulatory issues? It is unlikely that this asset swap would have occurred if LF Woodford Equity Income and Woodford Patient Capital were run by different management companies. 

Selling the unquoted companies could also be detrimental to LF Woodford Equity Income's growth potential. It holds shares in Woodford Patient Capital Trust, which has yet to see substantial share price growth. Since the trust's launch, its share price total return has been a loss of 21 per cent. It was trading at a discount to net asset value (NAV) of 18.3 per cent as of 29 March 2019, but LF Woodford Equity Income fund bought shares in it at NAV. So it will only benefit when the trust’s NAV rises and the share price catches up.

Mr Woodford’s focus for the past 18 months appears to have been on managing liquidity and the unquoted investments in LF Woodford Equity Income. And the asset swap undermines the raison d’etre of LF Woodford Equity Income. If you want UK equity income, you can invest in LF Woodford Income Focus Fund (GB00BD9X7109). And if you want exposure to early-stage, potentially high-growth companies, you can invest in Woodford Patient Capital Trust on an 18 per cent discount to NAV – rather than at NAV via LF Woodford Equity Income.

Poor stockpicking, questionable corporate actions and recent comments by Mr Woodford to IC's sister publication the Financial Times, which suggest he finds it difficult to remain calm under pressure, undermine the case for LF Woodford Equity Income. And Mr Woodford's strong track record was mostly built up in significantly different circumstances at Invesco.

So the time has come to sell LF Woodford Equity Income Fund.

Taha Lokhandwala

 

The hold case

A classic investor mistake is to buy high and sell low, and if you sell LF Woodford Equity Income at this point you are likely to make this mistake too. If you hold this fund you will almost certainly have bought it at a higher price per unit than the around 94p it is at now. And there is reason to believe this fund could recover.

LF Woodford Equity Income underperformed the FTSE All-Share index and the IA UK Equity Income sector average in 2016, 2017 and 2018, so its cumulative numbers do not look good. But in 2015 this fund outperformed strongly. And over his 30-year-plus career Mr Woodford has had other periods of underperformance, most notably during the tech boom, because he was not focused on this area, and approaching the financial crisis because he didn’t have exposure to banks. These calls served him well and the Invesco Perpetual Income and High Income funds' performance returned very strongly. Over his long career Mr Woodford has performed very well.

Mr Woodford’s funds historically have performed differently to indices and peers because of his investment style. He takes significant stock or sector bets, so his funds have performed quite differently to major indices. And he takes big bets on areas that are not necessarily fashionable at the time – a contrarian approach – but has recovered after periods of underperformance. He is also, to a certain extent, a value investor – an investment style that has been out of favour for a number of years, but could be set for a return.

LF Woodford Equity Income's current period of underperformance is partly due to its exposure to UK domestic-facing shares such as its largest holding, Barratt Developments (BDEV), and seventh-largest holding, Taylor Wimpey (TW.). UK-focused companies' share prices have fallen because investors have been taking their money away from UK shares, particularly those that make much of their revenue in this country. This is because of concerns over the economic impact of withdrawing from the EU – especially if this is done without a deal with the EU – and general lack of detail on what the terms of the withdrawal will be.

However, if there is a withdrawal with a deal in place – especially a softer Brexit than the Prime Minister's proposed deal – these shares could do better. And if the UK were to stay in the EU, these and other UK shares would be likely to enter a very strong bull run.

So if one of these scenarios arises, this fund could start to do well within the next year or two. But if you leave LF Woodford Equity Income now there is a risk that having sat through the years of poor performance you miss the turn.

if you cannot hold for five to 10 years and do not feel comfortable with periods of volatility, then this is not a fund for you. But if you have a high risk appetite, long-term investment horizon and are looking to add a contrarian bet to a large, well-diversified portfolio, LF Woodford Equity Income could be a good candidate, as it offers exposure to a basket of securities that could turn given the right catalyst. 

If you invest in an equity-focused investment you should have an investment horizon of at least five years. And if it is run via a contrarian style, which is high risk but potentially rewarding, you should hold for even longer to give its investments time to come to fruition. LF Woodford Equity Income has not been underperforming for anything like as long as this, and the fund only launched in June 2014.

No investment delivers good returns all the time, a reason why you should hold risk investments – such as funds focused on equities and bonds – for at least five years and in some cases longer. If you can wait for these time periods you could benefit from strong returns.

But with funds run by high-profile managers there seem to be unreasonable expectations of good performance all the time, year in, year out. This doesn’t happen with any fund – not even those run by star managers. But from the moment LF Woodford Equity Income and Woodford Patient Capital launched there was an assumption that they would immediately make high returns – a completely unrealistic expectation for funds invested in equities and unquoted companies. The former can take at least five years to deliver any sort of decent return, and the latter even longer. But many investors, as well as some brokers and analysts, appear to forget this when it comes to funds run by star managers.

A similar situation happened when Fidelity China Special Situations (FCSS) launched in 2010. This was run by high-profile manager Anthony Bolton and focused on Chinese equities – an emerging market asset that could deliver strong returns as these economies develop over the next five, 10, 20 or more years.

But when this trust similarly didn't deliver millions overnight and some of its US-listed holdings encountered problems, it moved to a discount to NAV because investors couldn’t understand why in a short space of time it hadn’t delivered the types of returns Mr Bolton’s previous funds had made over decades. However, towards the end of Mr Bolton's tenure in 2013, about three-and-a-half years after launch, this trust's performance had improved.

It is undoubtedly a problem that investors are withdrawing their money from LF Woodford Equity Income in large amounts. However, this is being carefully managed. Some of its holdings are large, liquid listed equities which are easy enough to dispose of to meet redemptions. There are also unquoted investments, which have been growing as a proportion of the fund's assets due to its overall size shrinking. But to avoid breaching the 10 per cent limit funds of this kind can invest in such assets, it has recently entered into a transaction with another fund run by Woodford Investment Management – Woodford Patient Capital Trust. It has swapped unquoted holdings of a value of £72.9m in exchange for shares in the trust. As a result, Woodford Patient Capital accounted for 1.45 per cent of LF Woodford Equity Income's assets at the end of February 2019.

If LF Woodford Equity Income needs to dispose of more unquoteds it could do more such transactions, so is unlikely to encounter problems meeting redemptions, as has been the case with some property funds focused on unlisted assets. Shares in Woodford Patient Capital are more readily realisable than unquoted holdings.

But the aim is for LF Woodford Equity Income to hold this trust for the long term, over which time it could do very well. This trust’s investments have started to come to fruition, but the real potential is yet to come. Woodford Patient Capital Trust only launched in 2015 and is invested in assets that should do very well over 10 or more years – as is the case with private equity. So a holding in this trust could be a valuable addition to LF Woodford Equity Income over the long term.

You could invest directly in Woodford Patient Capital. But it is a very different, high-risk proposition that is only suitable for very high-risk growth investors. For more mainstream investors, albeit with a good appetite for risk and long investment horizon, a good way to get some exposure to it alongside less risky holdings is LF Woodford Equity Income.

If Mr Woodford’s performance is anything like it has been in the past, LF Woodford Equity Income should ride out this period of underperformance and deliver strong long-term returns.

In the meantime, you are being paid an attractive level of dividends that result in a yield of over 4 per cent. If you do not want the income you could hold the accumulation share class (GB00BLRZQC88), where income is reinvested rather than paid out, and boost your return.

So don't follow the herd and make the mistake that investors keep making. Hold your nerve and profit from LF Woodford Equity Income.

Leonora Walters