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“Slower growth is a major challenge for global markets. This has been felt most acutely in Europe, emerging economies and in China and there is evidence that this slowing will continue through 2019. This, in turn, will raise earnings risk against a backdrop of excessive valuation in markets – a potentially dangerous combination. A further headwind as we approach the summer is a significant deterioration in global US dollar liquidity, which may be the catalyst for a much less benign market environment than that which we have witnessed in the first four months of the year. The comfortable consensus view that prevails in equity markets globally is about to be challenged.”
— Neil Woodford
Global equity markets continued to move higher in April, with similar preferences evident to those that have prevailed for much of the last three years. Accordingly, the UK market’s leadership again came principally from Asian-exposed businesses. We continue to see the widespread enthusiasm for the large, global-facing businesses that dominate the UK stock market as fundamentally flawed and increasingly dangerous from the perspective of valuation risk.
The loss of momentum in global economic growth has been widespread and is perhaps best epitomised by what’s happening in China and its local trading partners in Asia. China’s economic problems are well known, and a meaningful slowdown in growth has been evident over the last 18 months. Policy has been loosened slightly in response, and this has been enough to prompt a rapid stock market recovery in China, albeit one that remains highly speculative. Although official economic data seems to have stabilised in recent months, other, less malleable data points provide a better indication of what is really happening. These include domestic car sales, as an indicator of domestic demand, and industrial production and export data in other Asian economies that are dependent on Chinese growth. Here, the numbers remain troubling and it is increasingly difficult to reconcile the behaviour of equity markets with the economic evidence that we continue to see.
In recent months there has been considerable commentary about the shape of the portfolios Neil manages, in particular, the LF Woodford Equity Income Fund. In light of this, Neil explains why the fund is positioned as it is today and what this means for investors in the months ahead.
Source: Bloomberg, Office for National Statistics, Woodford
German GDP growth forecast for 2019, down from 2.1% a year ago
Latest change in China car sales (year-on-year)
Amount raised by Autolus for to support a new clinical trial in AUTO1, a potential treatment for adult acute lymphotic leukaemia
Latest change in Taiwan industrial production (year-on-year)
Potential value of ReNeuron’s partnership with China-based Fosun Pharma
Halifax house price index increased by a higher-than-expected amount in Q1 2019
UK retail sales rise in March, vs expectations of a -0.3% decline
Increase in UK employment in the three months to February 2019, to a record high level
US GDP growth for Q1 2019, much better-than-expected
Woodford Patient Capital Trust: April’s milestones
Several of the portfolio companies held in Woodford Patient Capital Trust plc (WPCT) reached significant milestones during April. They included Inivata’s valuation uplift and Benevolent AI’s collaboration with AstraZeneca.
Following a positive reimbursement decision in the US for Inivata’s maiden non-invasive blood cancer test and a successful $52.6m fund raising in March, the company’s valuation has this week been revised upwards by Link Fund Solutions Limited, WPCT’s appointed Alternative Investment Fund Manager (AIFM). The value of Inivata has increased by 58% and is valued at £31.2m.
Inivata is a clinical cancer genomics company commercialising its initial blood biopsy test that helps clinicians make more informed treatment decisions for patients with lung cancer based on their blood samples. Its initial test in the US is called InVisionFirst®-Lung and recent data demonstrated that it reveals the same quality of information as tissue-based cancer profiling in a less invasive way. As at the end of March 2019, it represented a 1.91% position in the WPCT portfolio.
Benevolent AI announced a partnership with AstraZeneca to identify new targets in two therapeutic areas of huge unmet need, Idiopathic Pulmonary Fibrosis (IPF) and Chronic Kidney Disease (CKD). The collaboration comes with an undisclosed upfront payment, development milestone payments and tiered royalties on future revenues.
Mene Pangalos, on the executive management team at AstraZenca, said: “By combining AstraZeneca’s disease area expertise and large, diverse datasets with BenevolentAI’s leading AI and machine learning capabilities, we can unlock the potential of this wealth of data to improve our understanding of complex disease biology and identify new targets that could treat debilitating diseases.”
As at the end of March 2019, Benevolent AI represented an..
In recent months there has been considerable commentary about the shape of the portfolios Neil manages, in particular, the LF Woodford Equity Income Fund (WEIF). In light of this, Neil explains why the fund is positioned as it is today and what this means for investors in the months ahead.
You may have heard me talk about my investment process in the past and despite its fundamental importance in guiding everything I do with the funds, it often gets overlooked and ignored. Because it is the thing that drives the strategy, what I own in the funds and what I don’t, I want to spend a little time explaining the key elements of that process.
Everything in my investment world begins and ends with valuation. It sounds simple and, in some ways it is, but before answering the question, “what is the right valuation for a business?”, I will explain why valuation is so important and why in the long term it is the most reliable predictor of future investment return.
On the basis that a picture paints a thousand words, let me start with one. The chart below shows the starting valuation of the UK stock market, in terms of its price / earnings ratio (PE), at the end of every year since 1974. This valuation is plotted against the real annualised total return that investors would have received over the subsequent 10 years if they had invested at that point.
UK equities: starting valuation has a strong influence on long-term returns
Source: Lazarus Economics, Woodford, based on FTSE All Share (excluding investment trusts) total return data in UK sterling, adjusted for CPI inflation; R2 = 0.6972
Nothing in investment comes close to the predictive power of valuation with respect to future returns. This is profoundly intuitive, even common sense, and all of us use valuation principles in everyday life. But, in the investment world, valuation principles don’t always guide investor behaviour. When financial markets lose touch with valuation principles, accidents always happen and crowded trades always blow up. This has happened throughout financial market history and has affected many different assets as diverse as tulip bulbs, property and of course most frequently, equities. Ultimately, the inevitability of a correction in overvaluation is certain. The timing of that correction, unfortunately, is not.
That is why investors get sucked into asset bubbles. Investors lose their perspective on valuation (the fear of missing out), crowd-like behaviour subjugates normal valuation discipline and momentum takes over. Investors rush into stocks that have risen in price and, typically out of those that have fallen, insensitive to valuation. Investors feel safe following these trends and, in the short term, that is likely to be a successful strategy because, by definition, it is being followed by the majority and to stand back from it invites opprobrium. But, in following a valuation insensitive strategy, momentum investors contradict the experience of history and the predictive power of valuation. Chasing over valuation because the majority of investors are doing the same thing condemns that majority to a rude awakening and, more importantly, poor future returns.
It is for this reason that I stick religiously to valuation discipline. It is the only way, in the long term, to insulate investors from permanent capital loss and importantly, to position them to benefit from attractive long-term returns. If you accept, as I do, that valuation discipline should be the foundation of a long-term investment strategy, it is incumbent on a fund manager that pursues such a strategy to explain clearly how valuation is judged. In this, again, I follow what I believe to be a common-sense approach.
The success or failure of most businesses pivots on the things that the business can control (for example the actions of management) and the things that it cannot, for example, the behaviour of the economy in which the business operates, the regulatory landscape and the actions of competitors. It is for these reasons I believe a comprehensive view on valuation can only follow the analysis of a business alongside the economic environment in which it operates. In essence, the micro and the macro.
Taken one step further, it should then become clear why an investment process, founded on a valuation discipline and drawing on corporate and macroeconomic analysis, will drive a fund manager towards certain stocks and away from others.
For example, if a business’s future success (as measured by its earnings) requires a level of economic activity that my analysis says is not going to be achieved then, by definition, its valuation is not going to look as appealing to me as it might to another investor who takes a different view. In essence, this is not a scientific process founded on absolute laws. It is a process which has subjective judgements about the future embedded within it. This is difficult, requiring extensive analysis and due diligence but there is no escape from it if one truly believes in a valuation discipline as I do.
There is one other point to make about valuation. It is not one dimensional. The chart above uses the price / earnings ratio (PE) as the proxy for valuation. This may be imperfect, but it is consistently so over time. I am content it is a good proxy for the valuation of public companies and furthermore data on PE ratios goes back a long time.
Having said that though, companies can be judged to be undervalued even when they don’t have any earnings, cash flows or pay dividends. We know this from everyday life, of course, (many things have intrinsic value that don’t deliver a cash return) but it requires a bit of explanation in a financial market setting. Let me give you a real-life example to illustrate the point.
Valuation case studies: Amazon and Inivata
One of the biggest companies in the world today, Amazon, grew rapidly over a twenty-year period following its IPO in 1997, but it was loss-making for several years and only modestly profitable until relatively recently. Nevertheless, it would be hard to argue that it wasn’t an undervalued asset through the early part of this history.
Another example would be a company that we have owned in the Woodford Patient Capital Trust (WPCT) portfolio for about three years. It is called Inivata. It has developed a technology (called liquid biopsy) which we believe will help to transform healthcare and especially cancer treatment in the years ahead. It is a technology, like so many others, that will disrupt incumbents but will also deliver better patient outcomes via quicker, cheaper, less painful and more accurate diagnoses. It is a business we have helped to nurture through its development phase, and it is now commercialising, having recently received a positive reimbursement decision from Medicare for its initial test, a non-trivial task.
Inivata is now clearly on the road to commercialisation and we have high hopes for it. But, is it an undervalued asset, is it cheap? It has as yet, no sales, profits or earnings and it pays no dividends. In our view, however, it is profoundly undervalued. We made this judgement through our own analysis of the business’s potential but, by way of proxy, we can compare it with its closest peer in the US, a company called Guardant which has also developed a liquid biopsy test.
Guardant’s test was approved about nine months ago and is further ahead than Inivata’s but we believe the Guardant test is less sensitive than Inivata’s. Either way, it is a directly comparable business. Interestingly, Guardant has a market value of almost $6bn (it is quoted on Nasdaq). Inivata, even after a recent valuation uplift, is valued at only $170m (it is held in our unquoted portfolio). In our judgement, this business is incredibly cheap, but it doesn’t fit in the conventional analytical model that looks at valuation through a PE and dividend yield lens.
In this regard, Inivata is similar to many of the smaller businesses we own in the Woodford portfolios. Businesses that we have analysed extensively and in which we have huge confidence but about which, more broadly, there is a lack of knowledge and an abundance of scepticism. I have to do a better job at explaining why these stocks are in our portfolios, how they fit our valuation criteria and why we believe they will deliver very attractive returns to our investors.
On the subject of early-stage businesses, it is clear there is a degree of nervousness about them within our investor base. My colleagues and I need to do more to educate and inform our investors about what these businesses do, why we own them and why we think they will deliver exceptional returns (and why we think they are so undervalued).
As we said on 1 March, our long-term intention is to not have any exposure to unquoted holdings in WEIF. Instead, the fund’s exposure to the unquoted asset class will come through listed investment vehicles, such as WPCT. This process is already underway and the fund’s exposure to unquoted securities (including those listed on less well-known exchanges where there is little or no trading activity) will decline over the remainder of this year to below 10%.
In some respects, this will naturally decline because many of the largest, less liquid holdings in WEIF are in businesses that we have been nurturing for many years (for example, I first invested in Oxford Nanopore almost a decade ago), and some of these businesses are maturing into companies that are ready for a full stock market listing. Some others are approaching inflection points where new investors are coming onto the register (for example, large overseas institutional investors) and these afford liquidity opportunities that we will be able to take advantage of where appropriate. It is also the case that some of the smaller early-stage companies in the fund have developed so quickly that they will, over the next few months, be launching full IPO processes (typically on Nasdaq).
The combination of all these carefully managed processes will mean that beyond this immediate period, WEIF’s exposure to these less liquid holdings will reduce further to significantly below 10% and, over time, to zero. Of course, my interest in these businesses will continue for as long as they remain undervalued, and WEIF investors will be able to benefit from the continued growth in many of them via their full market listings and through WEIF’s direct holding in WPCT.
Undoubtedly, the past three years have been difficult for our clients. Ultimately, the criticism I receive is driven by performance. Although I have experienced some company-specific disappointments, the fund has underperformed primarily because my valuation strategy has been completely out of step with a momentum-driven market.
As I said earlier, financial markets can for extended periods become detached from valuation fundamentals and whilst they do, fund managers like me appear incapable of delivering good outcomes. However, I hope I have demonstrated to you in this note that, in the end, valuation is what drives share prices and returns in the long run and that is why I remain resolutely focused on my strategy. I know the valuation disciplines deployed in everything I do professionally, and which guide the construction of the portfolios, will deliver the returns investors expect over the medium and long term.
To conclude this investment update, here is a brief outline of what I think will happen in markets over the immediate future and on towards the end of 2019. In the very short term, I believe there will be some important events which may catalyse a shift in broader investment behaviour not just with respect to the UK equity market but in markets across the world.
Although clarity on the interminable Brexit issue may still seem frustratingly distant, I believe that the odds of a softer Brexit have increased substantially as a result of the paralysis in Westminster. A no deal Brexit is now, in my opinion, extremely unlikely. I continue to believe that resolution will ultimately arrive through Theresa May’s deal being approved by Parliament (less likely) or a softer Brexit outcome (more likely) involving some form of long-term and close relationship with the EU.
If Brexit pans out as I believe, we will see a long overdue and significant rally in sterling – and this will have a meaningful impact on the UK stock market. It should at last liberate investors to start to acknowledge the underlying robust performance of the UK economy (last month we saw yet another series of strong data from the labour market and better-than-expected strong retail sales) and the profound undervaluation of companies exposed to the UK economy. At the same time these developments will also prompt the market to start to address the significant earnings and valuation risks in parts of the index where investors have significantly increased exposure over the last two years.
As far as the rest of the world is concerned, there are some very significant issues which investors should be paying attention to but aren’t, probably because the prospect of a US-China trade deal has got global investors very excited. From here, on that issue, there can only be disappointment. But, more importantly for global equities, slower growth now is the major challenge.
I have been saying for some time now that the world economy would slow and that this will be felt most acutely in Europe, emerging economies and in China. There is evidence that this slowing will continue in 2019. And because the US economy will also grow more slowly this year (under the weight of less fiscal stimulus and the lagged effects of last year’s excessive monetary tightening) global growth will slow further in the months ahead.
This, in turn, will quite obviously raise earnings risk against a backdrop of excessive valuation in markets, a potentially dangerous combination. A further headwind for markets, as we approach the summer is a significant deterioration in global US dollar liquidity, which may be the catalyst for a much less benign market environment than that which we have witnessed in the first four months of the year.
In summary, the comfortable consensus view that prevails in equity markets globally is about to be challenged by the issues highlighted in this portfolio update. The rest of the year is going to be very interesting and 2020 maybe even more so.
“From time to time, markets become detached from valuation reality and while they are, fund managers like me appear to be incapable of delivering good outcomes. I appreciate that this can be an uncomfortable journey for investors but valuation is the only reliable predictor of long-term investment returns. I remain focused on capturing the opportunity that exists in parts of the market that have been left behind since we voted to leave the EU two and half years ago. The portfolios are populated with profoundly undervalued companies, many that are exposed to the UK economy. Crucially, the portfolios are positioned how I want them to be and are completely focused on a valuation opportunity, the likes of which I haven’t seen for more than 30 years.”
— Neil Woodford
Global equity markets continued to move higher in March, allowing the UK stock market to deliver its biggest quarterly total return in six years. Leadership of the UK stock market was, as has been the case for much of the last three years, dominated by the large, global dollar-earners, such as the oil majors, mining companies and consumer goods companies.
Data from across much of the global economy, has continued to disappoint expectations. The US economy in particular, now appears to be losing momentum, prompting the Federal Reserve (the Fed) to significantly loosen its policy stance. Previously the Fed’s guidance had suggested two more interest rate increases were likely this year, with quantitative tightening (QT – the process by which the Fed reverses years of quantitative easing by reducing the size of its balance sheet, thereby withdrawing dollar liquidity from the financial system) expected to continue throughout the year. Now, the next move in interest rates might be down and the pace of QT will slow from May and will conclude at the end of September.
As a result of the stock market rally so far this year, bond and equity markets are now telling us very different things about the economic outlook. The yield on many long-dated US Treasuries, for example, recently moved below that of shorter-dated bonds. This is known as an “inverted yield curve”, which is often seen as an early warning sign that more troubling economic conditions are on their way. It is hard to reconcile this price behaviour in bond markets with the more buoyant mood in equity markets. We have more sympathy with the view expressed by bond markets currently and are positioned accordingly.
We continue to focus the portfolios where there are more attractive economic fundamentals. The UK is one such place. During March, we saw better-than-expected economic data in many different parts of the UK economy, including industrial production, unemployment, wage growth and retail sales.
WPCT annual report
Today saw the release of the Woodford Patient Capital Trust’s annual report for 2018, which includes Neil’s review of the year.
With so much perceived uncertainty surrounding the UK economy, we want to provide you with the full context on what’s been driving the performance of the funds (and indeed the broader stock market) for the past few years and the opportunities we believe lie ahead.
“There has been some renewed commentary recently about the shape of the portfolios. Inevitably, I have faced some difficult decisions about what to sell during a period of redemptions, but I have accessed liquidity across the market cap spectrum to ensure the portfolios are exposed to what I believe to be the most attractive opportunities. They are in the shape that I want them to be. In fact, there have been very few occasions over the last thirty years when I have felt more positive about the outlook for the funds I manage.”
— Neil Woodford
Most global equity markets sustained January’s strong performance into February, helped by a dovish tone from the Federal Reserve, a stronger oil price and suggestions of a thaw in China-US trade relations. The UK equity market was no exception, with leadership coming primarily from dollar-earners, such as the large index constituents in the pharmaceuticals, oil and mining sectors.
Month in numbers
Source: Bloomberg, Office for National Statistics, Federal Reserve Bank of New York, EPFR Global, China Association of Automobile Manufacturers
Number of people (aged >16) in employment in the UK – the highest ever level
European Union’s 2019 growth forecast for the eurozone – downgraded from 1.9%
Public sector budget surplus in January 2019 – the largest monthly surplus since records began
Number of Americans more than 90 days behind on their car loan payments
Eurozone industrial production declines in December 2018, worse than expectations
Weekly pace of European equity fund outflows during February – fastest pace since the Brexit vote in 2016
Sterling / euro exchange rate at its highest level since May 2017
UK GDP growth in Q4 2018 – slightly below expectations
Passenger vehicle wholesales in China fall in January, at fastest rate in more than two decades
As announced last week, the LF Woodford Equity Income Fund (the fund) has recently transferred some of the portfolio’s individual unquoted stocks to Woodford Patient Capital Trust (the trust) in exchange for shares in the trust. This is the conclusion of almost eighteen months of work. We first discussed the concept of moving the equity income fund’s unquoted exposure to a position in the Woodford Patient Capital Trust, in late 2017. It has been a lengthy process involving numerous parties to ensure that it has been executed in an appropriate way and that it is in the best interests of investors on all sides. We want the fund to remain exposed to this part of the asset class because it represents a very exciting and compelling investment opportunity, but this move signals the start of a strategy to switch the fund’s unquoted exposure from individual holdings to shares in the trust
Our strategy remains focused on avoiding the considerable risks that have built up in equity markets over the last decade of QE-fuelled exuberance and capturing the opportunity that exists in the few parts of the market that have been left behind. For the funds, this results in portfolios that have a strong but selective bias towards profoundly undervalued companies that are exposed to the UK economy.
Elsewhere, the Woodford Equity Income Fund and Woodford Patient Capital Trust portfolios continue to be positioned to capture an exciting long-term opportunity across a range of earlier-stage businesses exposed to the themes of healthcare innovation and disruptive technology more broadly.
As announced last week, the LF Woodford Equity Income Fund (the fund) has recently transferred some of the portfolio’s individual unquoted stocks to Woodford Patient Capital Trust (the trust) in exchange for shares in the trust.
This is the conclusion of almost eighteen months of work. We first discussed the concept of moving the equity income fund’s unquoted exposure to a position in the Woodford Patient Capital Trust, in late 2017. It has been a lengthy process involving numerous parties to ensure that it has been executed in an appropriate way and that it is in the best interests of investors on all sides.
We want the fund to remain exposed to this part of the asset class because it represents a very exciting and compelling investment opportunity. We have helped to build some very impressive businesses within this part of the portfolio. Some remain at a relatively early-stage of their development but are making tangible progress on the road to commercialisation. Others are well-advanced on that journey and are now at a stage where a stock market listing in the near future would appear appropriate. Not everything has gone according to plan but, in aggregate, the unquoted part of the portfolio has added meaningfully to the fund’s performance since launch, and we are very confident that it will continue to add significant value.
Woodford is the investment manager for both the fund and the trust. Link Fund Solutions is the ACD/AIFM for both products and is responsible for the valuation of all unquoted holdings in both products. The unquoted valuation process is completely independent of Woodford and is line with International Financial Reporting Standards and International Private Equity and Venture Capital Valuation Guidelines. Unquoted valuations are revisited every six months, or more frequently if milestones are reached, further funding is raised or if other relevant events occur. Link utilises the services of IHS Markit, an external independent valuer, in this process.
The valuation of each co-held asset is therefore the same in both products. It is our agreed policy with Link and Northern Trust (as Depository), that if an asset is to be transferred between mandates, the most recent valuation point must be less than two months old.
In light of the above, all of the five assets had been revalued by Link and IHS Markit within the two months prior to the transaction. As is required under the Companies Act when acquiring new shares for non-cash consideration, the assets transferred have to also be independently reviewed by an appropriately qualified and independent auditor. Duff & Phelps was appointed by the WPCT Board to carry out a review of the valuations of the the assets being transferred. It subsequently confirmed all five valuations were fair and reasonable.
Who represented WPCT shareholders interests during the negotiations?
The trust’s Board represented the interests of its shareholders throughout the period in which this transaction was being discussed and agreed. Susan Searle, Chairman, Woodford Patient Capital Trust, said:
“This is a highly positive transaction for shareholders. We’ve increased positions in portfolio companies, in which the Board and the manager has conviction. The Trust has raised funds at a significant premium to the current share price, resulting in no dilution to shareholders and a scaling of the Trust.
“The Board sought advice from a range of parties and had the companies, which we already own and know well, independently valued. This deal has been something we have been considering for many months and the Board, which is fully independent, has debated the merits of this transaction with its advisors and concluded it is a positive deal for its shareholders.”
Will you publish the independent valuation reports?
Transparency is at our core, and we have led the industry on this issue. However, we are not prepared to publish any unquoted valuation reports, as they can contain sensitive information which is not in the public domain. Furthermore, given the independence of the unquoted valuation process, technically, these reports are not ours to publish.
How much of the fund is invested in unquoted companies, post-transaction?
As a UCITS fund, there is a restriction on the amount that can be invested in securities that are not listed on an eligible market, such as the London Stock Exchange. No more than 10% of a fund’s assets should be invested in securities that do not meet the eligibility criteria as defined by UCITS requirements.
Although generally the securities that fall into this limit are those that are not listed on a market, there are a few nuances that mean it is not a straightforward calculation. Examples include:
Securities that are quoted but that are listed on an ineligible market
Recently issued unquoted securities where there is an undertaking to apply for admission to an eligible market within 12 months of issue
This means that some of the fund’s quoted securities are classified as unquoted for the purposes of this calculation. Meanwhile, some unquoted securities are classified as quoted because there is a documented intention to list.
As at the end of February 2019, the fund’s exposure to securities classified as unquoted for the purposes of this calculation, was just under 8%. The calculation and classification of securities is also constantly monitored by Link, as ACD for the fund.
Irrespective of these classifications, the important thing to focus on is the quality of companies that we have invested in. This is why we publish the full portfolios each month and provide investment case summaries and regular updates on the largest positions. The opportunity that lies ahead of these businesses is much more important, in our view, than whether they are classified as listed or unlisted.
How will Woodford manage the potential conflict of interests here?
The potential conflicts of interest have been thoroughly assessed and managed in terms of both sets of shareholders, not just by Woodford, but by all parties involved in the transaction. We have worked closely with Link as ACD/AIFM and Northern Trust as Depository for both products to ensure that all potential conflicts of interest are appropriately managed. Within Woodford, these were (and will continue to be) reviewed through our Governance and Risk Management Frameworks.
From a trust perspective, the transaction was approved by the Board and reviewed by its external third parties, including Stephenson Harwood as its external counsel. The strategy across the two products has been discussed at length between all parties to ensure that the transaction is in the best interests of investors.
Will you be double-charging?
Typically, if a fund buys another fund (or trust) under the same management, it waives its own fee to avoid ‘double-charging’. In this instance, however, we do not charge a fee for the management of the Woodford Patient Capital Trust. The ongoing charges (currently 0.18% per annum), purely cover the costs of running the trust. As such there is no management fee to waive.
There is, however, the prospect of a performance fee, which will accrue once the trust’s net asset value growth exceeds a hurdle rate of a cumulative 10% annualised return. We are conscious of feedback from some investors, who would like to see us take steps to ensure any future performance fee from the trust does not result in double-charging. We are therefore exploring our options here, but no decision has yet been taken.
Did the trust seek shareholder approval for this transaction?
The Board has undertaken its own independent analysis on the merits of making the transfer. The trust does not need approval from shareholders as the new shares have been issued under its current authority to annually issue up to 10% of the Company’s issued ordinary share capital. That authority was approved by shareholders at the AGM in June 2018. It deliberately sought to ensure there was no dilution.
Does buying the trust at net asset value mean an immediate loss for the fund?
Yes, the value of the trust holding in the fund will be valued at the prevailing market price, rather than its net asset value (NAV). The prevailing price is currently below the trust’s NAV, so this does mean a small loss for the fund on the transaction in the short-term. However, we have explored how much it would cost the fund to purchase the equivalent position in the secondary market and our analysis suggests it would cost more and take significantly longer, than buying at NAV in this way. The fund is paying what the trust’s assets are actually worth and we are doing this with the belief that the assets will significantly appreciate over the medium-to-long term.
Meanwhile, on the other side of the transaction, issuing shares to the fund at NAV (plus costs) ensured that trust shareholders did not suffer any dilution.
We wanted to let you know that the LF Woodford Equity Income Fund (the fund) has transferred some of the portfolio’s individual unquoted stocks to Woodford Patient Capital Trust (the trust) in exchange for shares in the trust. This step signals the start of a strategy to switch the fund’s unquoted exposure from individual unquoted holdings to shares in the trust.
Which unquoted positions have moved across?
Atom Bank, Carrick Therapeutics, Cell Medica, RateSetter and Spin Memory have transferred from the fund to the trust. All of them are existing positions within the trust portfolio. The combined value of these assets is £72.9m. A further £6.0m in cash has also transferred from the fund to the trust, to meet the anticipated capital requirements of these assets over the next twelve months.
Why have you chosen these particular stocks?
We have selected from a list of positions in which the trust already has a holding, and have avoided stocks where we believe there is a known likelihood of an imminent milestone being reached that would trigger a near-term valuation change. Indeed, an additional valuation report was commissioned by the trust’s board which, as required under the Companies Act, independently verified the reasonableness of the valuations of the five stocks transferred.
Furthermore, several of the larger unquoted positions within the fund are also already well-represented within the trust portfolio. As these businesses are typically at a more mature stage of their growth cycle, other forms of corporate activity could arise in the short-to-medium term that would further reduce the fund’s aggregate exposure to unquoted securities. Evidence of this was provided yesterday by Proton Partners International, which has listed on London’s NEX Exchange Growth Market. The acquisition of the selected assets allows the trust to increase its position to companies that the board views as the “the second-wave of global disruptors”.
How has the transfer taken place?
The trust has acquired this portfolio of assets for £78.9m (including the cash element) through the issuance of 81,639,238 new ordinary shares. The shares have been issued to the fund at a price of 96.67 pence per share which is equal to the net asset value (NAV) per share as at 27 February 2019, plus the costs associated with the transaction.
In buying the shares at the trust’s NAV, the fund is buying its stake in the trust at a premium to the prevailing share price. We have explored how much it would cost the fund to purchase the equivalent position in the secondary market and our analysis suggests it would cost considerably more and take significantly longer, than buying at NAV in this way. The fund is paying what the trust’s assets are actually worth and we are doing this with the belief that the assets will significantly appreciate over the medium-to-long term.
Why have we transferred these unquoted holdings?
This step signals the start of a strategy to switch the fund’s unquoted exposure from individual unquoted holdings to shares in the trust. Neil is as passionate on the unquoted asset class as ever but having listened to feedback from clients we believe that moving the exposure to the asset class via a collective fund rather than individual unquoted stocks makes sense – both operationally and from an investor view.
Furthermore, in making this move, which coincides with the LF Woodford Income Focus Fund moving from the IA Specialist sector to the IA UK Equity Income sector, we believe we have a more clearly defined product set, making investor choices easier to make:
“The UK economy entered 2019 with positive momentum and looks well placed to continue to strengthen as the year progresses. This will, in my view, contrast significantly with almost every other large developed economy, including China, where recent data has been worryingly weak. In Europe, the disappointing data we saw in the second half of 2018 is getting worse, Japan is not growing at all, and I believe the US economy will slow as the year progresses. The UK’s economic performance in 2019 will, in that context, stand out from most of its peers.”
— Neil Woodford
Equity markets enjoyed a robust start to the year, rebounding from December’s declines. Global macroeconomic data appeared to resonate more with the market behaviour at the end of last year, however, with weakness particularly evident in China and Europe, and growing concerns about the outlook for the US economy.
Towards the end of the month, the Federal Reserve (Fed) responded to the deteriorating economic environment by signalling that it is pretty much done with interest rate hikes for now and intends to be more flexible about the pace of its balance sheet ‘normalisation’ through the process of quantitative tightening (QT).
Although this evolution of Fed policy may have contributed to the near-term rally, the implications of a deteriorating backdrop are not positive for most risk assets from a longer-term fundamental perspective. Indeed, we expect the US to join the rest of the world in this more challenging economic environment, with very few regional economies possessing enough internal momentum to withstand the slowdown that is already in train. The UK economy is one of these rare exceptions.
The Bigger picture
Things continue to look challenging for the eurozone economy. The last time the 200-day moving average of the Citi Eurozone Economic Surprise index was this low was at the depths of the financial crisis pic.twitter.com/JEexKMpuIP
“Despite more than a decade of efforts to rebalance the economy and wean itself off the stimulus introduced in the wake of the 2008 financial crisis, China remains addicted to ever-higher levels of debt and construction.”https://t.co/at9e8hLrfG
This article is important because it highlights the phenomenally attractive investment opportunity that currently exists in UK-exposed assets. The Woodford funds are positioned to capture this opportunity.https://t.co/xLWxYpLKrG
“We are consistently seeing macro data that reflects the underlying strength of the UK economy. The UK labour market continues to improve and that, more than any other single issue, is the most important determinant of the more upbeat view I continue to hold about the outlook for the domestic economy.”
— Neil Woodford
December was another volatile month for global equities. Markets continued to be buffeted by concerns about the global economic environment and the extent of valuation stretch among popular growth stocks, particularly in the technology sector. As the Brexit talks move through their final stages, the UK market was especially volatile, with rapid changes in the perceived balance of probabilities causing sharp shifts in intra-month performance.
The Bigger picture
Although the UK stock market has remained preoccupied by the ebbs and flows of the Brexit debate, the UK economy has continued to produce strong data. Towards the end of 2018, we have seen further positive numbers on wage growth and employment, backed up by more good news on inflation. With the lowest unemployment since the 1970s, strong growth in employment and hours worked, combined with the fastest real wage growth since the financial crisis, we enter 2019 with strong economic momentum in the UK.
Meanwhile, the rest of the world economy is gradually looking less robust. China is very visibly slowing, emerging economies continue to struggle with dollar strength and higher dollar borrowing costs, and Europe has slowed significantly. The weak oil price that was evident in the final months of 2018 is, from our perspective a reflection of this backdrop, with much weaker demand growth than the consensus had expected, as well as more robust supply growth.
The US economy is still visibly strong but the waning influence of fiscal stimulus, allied to the lagged effects of much tighter monetary policy, are beginning to challenge policymakers and financial markets. Bond investors appear to be pricing in a much more challenging economic environment and the correction that appears to have started in the equity market is another warning of more troubling times ahead.
Our strategy remains focused on avoiding the considerable risks that have built up in equity markets over the last decade of QE-fuelled exuberance, and capturing the opportunity that exists in the few parts of the market that have been left behind.
Over the course of the last two years, we have seen a very attractive investment opportunity emerging in domestically-exposed stocks, which have been increasingly out-of-favour since the UK voted to leave the European Union in June 2016. As the negotiations with Europe have progressed, uncertainty about the path of the UK’s future relationship with Europe has increased. The UK has consequently fallen heavily out of favour with global asset allocators and, within the UK stock market, a significant gap has opened up between the performance and valuation of international-facing stocks and domestically-exposed stocks. The open-ended funds have progressively increased their exposure to the latter, selectively focusing on stocks which are pricing in a bleak scenario for the UK’s future, which stands in stark contrast to the much more positive economic data that we are seeing.
Elsewhere, the Woodford Equity Income Fund and Woodford Patient Capital Trust portfolios continue to be positioned to capture an exciting long-term opportunity across a range of earlier-stage businesses exposed to the themes of healthcare innovation and disruptive technology more broadly.
Welcome to the fifth Woodford Christmas quiz. The format matches those of previous years. Clicking on the link below will take you through to the questions, a mixture of picture clues that form finance-related names and phrases, along with some legend-less charts for you to identify.
All entries must be submitted by midnight on 20 December, with the winning entries to be drawn on 21 December. Winners will be contacted by email the same day, with the prizes being champagne for the winner and six copies of Red Flags, by George Magnus, for the runners-up.
Thanks go again to Simon Bond at Redburn for his efforts on the questions. Chart data is sourced from Bloomberg as at 10 December 2018.