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Woodford confronts his critics: The full interview

Neil Woodford

Earlier this week, Neil Woodford, Invesco Perpetual income manager, took part in a live webcast in which he answered questions from the intermediary community, put to him by an independent financial journalist. Here is the full transcript.

Q: What has changed that has caused the performance of your funds to falter in the short-term and how difficult has it been to hold your nerve as a fund manager?
A: The reason we have had a difficult period is because my focus on valuation has not chimed with the market’s focus with momentum. The market has been very geared into expecting an economic recovery and has been bidding up the share prices of companies that are focused on such an economic recovery, and to a large extent has been ignoring companies that fall outside of that sphere. The momentum has carried on strongly over this two-year period and we have been out of step with the market as a result of that.
It has been difficult to ’stick to our knitting’. However, we have a very disciplined approach to investment – we focus on fundamentals; we focus on valuation – and that strategy has not been working in the short term. I am, however, absolutely convinced that, in the long-term, valuation and fundamentals of a company are the only things that matter and, like gravity, those things will reassert themselves.

Q: Is this something that you did not anticipate or are you, in some way, not completely unsurprised that you and the market are out of step with each other?
A: After the financial collapse and the stabilisation of the monetary system, we expected a rally in the market and that rally was always going to be led by the most economically sensitive stocks. Having performed very well, relatively, in the sell-off, we expected to give something back in that early phase of the recovery. What has surprised us has been the extent to which that trend has been stretched into a period of disappointing economic news. We do not focus on short-term performance issues; we focus on the valuation of fundamentals. Our disciplined approach guides us, we believe, to the best opportunities in the stock market and we are very patient investors. We expect our performance to improve when the market begins again to focus, as it inevitably will, on valuation.

Q: Do you see the relative underperformance of value stocks changing in the near future, and what would be the catalyst for that change?
A: Many commentators in the market and analysts recognise the undervaluation of certain parts of the market where we have significant investments, but, by the same token, say, ’There is no reason to buy them at the moment because I can’t see a catalyst.’ I am not sure that I have ever really identified a catalyst that has changed anything. It is hard to identify, even now, what the catalyst was in March 2000 that changed the market’s perception of ’old economy’ stocks versus ’new economy’ stocks. The catalyst that I focus on most of all is valuation; valuation is the only catalyst that I really trust. In the long term, therefore, I am very confident that valuation will reassert itself.

Q: Turning to the international scene that is dominating the headlines at the moment, what effect will the events in Japan and North Africa have on global inflation?
A: One primary result of Japan’s catastrophe and the events in North Africa and the Middle East has been higher energy prices, and you might argue that that would be inflationary. However, my best guess is that because high energy prices act like a tax on consumers in energy consuming nations, it is actually ultimately disinflationary because it extracts spending power from consumers’ pockets. Unless you are expecting high energy prices to filter down to high wages – which I do not expect because of the slack in most western economy labour markets – then the high energy prices will not be inflationary.

Q: What about the loss of industrial capacity in Japan as a result of what has happened there?
A: That will be a short-term influence. You will see a dip in production in this quarter and next quarter while much of Japanese industry is having to respond to power shortages etc. But when Japan gets itself back on its feet, which I am absolutely sure it will, what you do not see in terms of growth this year, will be seen next year to some extent as Japan rebuilds devastated areas and its production inventory.

Q: What happens to UK quoted shares that are not isolated from the rest of the world? You have a lot of overseas earnings in your funds, so could you give an insight into your view of the international outlook?
A: To put it into context, the UK accounts for only about a quarter of the revenues of all the companies that I am investing in. If you added up the portfolio’s revenues, about a quarter of them come from the UK, about a quarter come from Europe, a quarter from North America and a quarter from the rest of the world, so it is a pretty even split.
Therefore, what happens internationally is very important to the portfolio. It is also very important because we live in a globalised economy; all the events happening in Japan, North Africa, the Middle East, and, indeed, in North America and China, have an influence on the behaviour of the stocks in the UK market, therefore in order to invest wisely, you do have to have a global perspective all the time.

Q: It is looking like there will be a rise in the UK interest rates next month. Do you see that as a policy mistake? Do you accept the premise that there will be a rise in interest rates?
A: It is a difficult one to call. There is pressure for an interest rate increase because the inflation numbers have been consistently higher than the 2% target that the Monetary Policy Committee (MPC) is targeting, so many economists in the City have been expecting an interest rate increase this year. My own view is that we will not see an interest rate increase.
This is driven, first and foremost, by my view that putting up interest rates will not change the UK’s inflation rate. The high inflation rate we are seeing currently is a function of things outside the control of the MPC; it is largely a result of tax increases, excise duty increases, imported food and imported energy costs. Consequently, putting rates up is only going to crush the consumer, who is already having a difficult time in the wake of fiscal austerity, and will not have an impact on those influences. I think the weakness of the consumer economy in the UK will defuse the appetite for higher interest rates. As we know, the MPC is split on this. An important point to make here is that there is really a contract between the monetary authority and the Government. Whilst the Government continues with Plan A, which is continuing to get the deficit down and fiscal austerity, I think the MPC will be comfortable in keeping the rates as they are. If there is slackening in the attitude towards fiscal austerity, then I think the interest rates would rise.

Q: Staying with domestic policy, how do you think the coalition government is doing in tackling the budget deficit? What impact from their strategy do you expect?
A: This Government knew, and knows very well, that starting from April, the fiscal austerity package will bite and this will be unpopular; it has been reported that 250,000 people, at least, were on the streets of London protesting against the cuts. It is a brave strategy and it allows us to get away with a continuation of the very low interest rates that we are enjoying at the moment. The challenge will come over the next two to three years of this Government.
As we approach the next election you may well see the brakes coming off a bit and a bit more fiscal stimulus coming. Much of the reduction in the deficit depends on underlying growth coming through in the economy, and that is where I am very cautious as I do not see the growth coming through in the way that the Chancellor has forecast and consequently believe that the deficit will come down much more slowly than he thinks.

Q: Your funds appear to be very cautiously positioned with high conviction placed in the more defensive sectors; what do you see as the potential threats to your positioning?’
A: While the pharmaceutical and telecom sectors that I have significant exposure to are perceived as defensive, I am actually very excited about the undervaluation opportunities in these sectors. I am more interested in the opportunity that these companies have to deliver exciting returns to investors going forward.

Q: With corporate earnings continuing to be robust, what would you need to see to rotate away from the defensive sectors? How would you position yourself if – a big if – you became more positive about the UK economy?
A: There are a lot if issues in that question. What drives my investment process is valuation. At the moment, the best valuation opportunities in the stock markets are in the sectors where we have significant positions; most notably pharmaceutical stocks, telecoms and tobacco. They happen to be defensive companies at the moment, but they are also growth companies. They are delivering growth in earnings, cash flow and dividends; these are all very important in terms of what one looks for from an investment.
The economic environment is very challenging at the moment and is likely to remain so for some years to come. I think some of the expectations that are embedded in the market in terms of earnings progression from some parts of the market that we are not exposed to are very optimistic, and that the stock market will struggle to deliver the earning expectations that are now embedded in many share prices.
What will drive a shift in the portfolio is the same thing that has driven the positioning of the portfolio to date; when other parts of the market become very cheap and undervalued, they will become more interesting to me. At the moment, and to my mind for the foreseeable future, the best valuation opportunities are in these areas of the market that are currently unpopular, but where I have huge conviction about the potential to deliver decent returns.

Q: Two questions on your exposure to the pharmaceutical sector. Are you spreading your risk sufficiently if you are putting 25% of your fund into just one sector, and why are you so confident that Glaxo and Astra are undervalued – they both face a patent cliff and may not be very successful in converting R&D into future revenues and profits?
A: Yes, the diversification argument is very relevant. Are we overly exposed to this sector? My answer to that is, no, we are not. In fact, I am looking to increase our exposure to this sector because this reflects the degree of conviction that I have about the undervaluation of this sector. I have in the past been more concentrated in one particular sector than I am today in pharmaceuticals. For example, during the 1990s I had more than 30% of the portfolio in banks.
In terms of the fundamentals – the patent cliff, the challenges of the R&D pipeline and the lack of productivity from R&D – all of these issues are well known and well rehearsed. What is not well rehearsed, and what the market does not focus on, are the opportunities. There are opportunities in both the emerging world, where there is a huge un-met demand for the drugs that consumers cannot get access to from domestic manufacturers, as well as in the developed world, where aging demographics are driving increased demand for drugs. Globally there is an increasing prevalence of the diseases that are treated with the drugs that these companies innovate, produce, market and sell.
These companies have got to innovate and deliver therapeutic benefit through innovation, but I am very confident that they will continue to do that. It is important to bear in mind that you are not paying for the pipeline.
You don’t have to believe in these companies innovating and producing new drugs; the share price valuations are so depressed, that you can pretty much discount any further innovation or new drugs coming to the market from these companies. If you just focused on what they already have on the market, and the patent lives of the drugs they already have on the market, the valuations still look very, very appealing.

Q: When do you expect to see the value in the pharmaceutical sector being recognised?
A: This is another catalyst question; what is the catalyst that will trigger a reappraisal of the attractions of this sector? Many of the analysts who are neutral or negative on this sector recognise the undervaluation, but are structural sellers because they cannot see the catalyst that would change investor perception. I do not invest like that.
I invest on the basis of where the best value is. Valuation is the catalyst that I rely on and valuation will be, eventually, the trigger that will lead to better performance. I cannot tell you what it is, or when it will happen, but the longer it goes on, the more testing it will be for the market to ignore the fundamental valuation in this sector, which is unprecedentedly attractive. There have only been a few occasions in my career where I have seen opportunities like the ones that I see now in the pharmaceutical sector.

Q: Turning to the banking sector, in view of the profits being generated and the fact that they are ’running rings around politicians’, shouldn’t you be investing in the banks now?
A: The short answer is, no. I do not accept that they are running rings around the politicians. In terms of the bank bonus debate, I think the question is absolutely right; it is very hard for the Government to get its way with respect to remuneration in the banking industry. Remuneration is a globally set standard and domestic banks have to pay up for the staff that they want to attract and retain in their organisation. If they are forced to reduce compensation, then the best people in those banks will migrate, as they have in the past, to other institutions that are not subject to those controls.
However, to suggest that the banks are running rings around regulators would be a mistake. We will learn more about the challenges facing the banks when the Banking Commission reports later this year, but the banks are likely to have to hold much more capital going forward and to be subject to much more intrusive intervention and regulation.
These are challenges that the market would be wrong to underestimate. We continue to be very nervous about the sector and to believe that there are many more attractiveinvestment opportunities elsewhere in the market.

Q: Is the tobacco sector going to remain a good producer of income?
A: Again, a short answer to the question is absolutely, in my view, yes it is. But to describe the tobacco sector as a ’good producer of income’ would be to massively understate its achievement over the last 25 years. Over the past 25 years the sector has produced total returns of about 9,200% – the best performing sector by a country mile. Part of the reason the sector is structurally undervalued is because it is a structurally unpopular sector.
It continues to be unpopular; it continues to be subject to tighter regulation and increasing excise duty, etc. But the tobacco sector has, through focus and good management, but largely through the inherently attractive cash generation characteristics, been able to produce very attractive returns to investors, and should continue to do so despite the headwinds that it continues to see.

Q: Has your opinion changed with regards to the oil majors? What themes do you think will likely play out in the next few years?
A: It would be wrong to oversimplify our approach to the oil majors. We have a very big position in BG; we are one of their biggest shareholders. We are very confident about the business and the growth in the underlying business, both in terms of its LNG (liquid natural gas) portfolio and in terms of its upstream business. It is a business that has been able to deliver fantastic resource growth: a very successful oil and gas major. On the other hand, though, for example BP and Shell, we believe, are very challenged going forward despite higher oil prices. The problem is that the costs of finding and exploiting resources on a scale that can offset the decline in production from their existing acreages is going up and has gone up a long way and these companies have to invest a huge amount of money to replace those diminishing resources. Again, we come back to the point that we can find better alternatives elsewhere in the stock market. I am not saying they are bad companies; I am not saying they are bad investments, per se. I am just saying they are challenged and their valuations, to my mind, do not look as attractive as the areas where we have greater focus.

Q: Why does your portfolio have such a long tail of small holdings? Over the time that you have included small holdings within your portfolio, have they provided any significant additional value?
A: We are looking at every company, whether it is an unlisted security or whether it is the biggest PLC quoted in London. We are looking at it through the same lens: is this an undervalued investment opportunity? The long tail reflects my desire really to build a portfolio of investments in companies that we believe will become significant over time. Some of those are essentially in businesses where we have effectively a part-paid investment. These are small companies that we believe will grow and will require capital to grow, and we are happy to provide that capital. We are trying to invest in the companies of tomorrow and select those businesses that we believe can deliver attractive returns. Obviously, the risks are higher in this sector, and so our expectations for return have to be commensurately higher as well. We are very confident about this tail delivering returns to investors and, in fact, when we have analysed performance from the tail relative to the overall portfolio, the contribution has been very significant, second only to Reynolds American over the last three to five years.

Q: The Invesco Perpetual High Income fund has not done as well as other funds within its sector. Could you address that issue?
A: In order to answer that question comprehensively, I would need to know what all those other funds, with which I am being compared in the same sector, own, and I donot. My best guess is that they have a spread portfolio; they probably have greater exposure to the mining sector, for example, or to other parts of the market which have done well, particularly the mid-cap sector, for example, which has significantly outperformed large-cap for a number of years now. As I said in answer to your earlierquestions, we are very convinced about the strategy of the portfolio, and about the discipline that we bring to bear in terms of our investment process. We have a fantastic opportunity, we believe, in the stocks where we have investments and we are being patient. We believe, in time, this strategy will pay out.

Q: You were quoted recently as saying, ’This is a once-in-a-decade investment opportunity.’ What do you actually mean by that?
A: The stockmarket is structurally inefficient. There are always valuation anomalies in the stock market and my job is to try and exploit those, by exposing the portfolio to undervalued stocks. The extent to which fundamental value diverges from the stock price flexes over time; you do not always see the same quantum of valuation opportunity in the stock market. During the technology bubble the disparity between price and fundamental value was stretched astronomically in both directions. In the 25-ish years I have been managing money and the 23 years I have been managing money here in Invesco Perpetual, there have been one or two occasions when you have had that sort of opportunity, and I see an opportunity of that scale now in the stock market. So the context is that this is a career-type of opportunity, and they do not come along very often.

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