August is typically a quiet month for the UK equity market but, as many of our investors are acutely aware, the relative calm of the holiday season was disrupted by a significant profit warning from Provident Financial and a general mood of market antipathy towards much of the rest of the portfolio.
The profit warning from Provident Financial, which came hard on the heels of its warning in June, has been an obvious headwind to performance. This arose from continued and worsening problems for its consumer credit division. Broadly half of the portfolio’s underperformance in August came from Provident Financial – much of the rest, in our view, is the result of the stock market’s current preferences, which have become extreme.
As the summer has progressed, global stock markets have become increasingly narrowly focused, returning to the themes that drove behaviour in the second half of 2016. Markets have appeared singularly fixated on stocks that are seen as proxies for Chinese credit growth – in the UK that basically means mining and consumer goods companies – with the rest of the market languishing behind. We do not believe this behaviour is fully justified by fundamentals – nor do we believe it is sustainable. Nevertheless, it has been a considerable further headwind to performance in recent weeks.
Furthermore, we would argue that this behaviour has introduced more risk to certain parts of the market. To demonstrate this, let’s look at what’s happened to Diageo* – a stock we don’t own – over the course of the last eighteen months. Diageo’s share price has risen 48% from its near-term low of £17.48 in June 2016, to end August at £25.92 (much of that share price rise has come in the last few weeks). In June 2016, the company was expected to deliver £1.02 of earnings per share in the current financial year (which ends on 30 June 2018), putting the shares on a prospective price / earnings ratio (PE) of 17.1x earnings.
We have previously made the point that starting valuation (the price you pay when you buy an asset) has a strong bearing on the long-term return that you get from that asset. This applies as much for single stocks as it does for broader asset classes, such as the UK stock market as a whole. Diageo has many attractive characteristics as an investment but, from our perspective, valuation is not one of them, particularly when you consider that this is a business that has been growing earnings at an average rate of 3.3% per annum over the last five years.
Part of the share price performance we have seen since June last year has been justified by fundamentals – forecasts for earnings in the current financial year have risen by 15% (albeit currency fluctuations explain part of that increase), so that at the end of August, the consensus forecast for this year’s earnings per share is £1.17. If Diageo’s share price had also risen by 15%, its PE would have remained the same – but the share price has of course risen by much more, to £25.92 so the PE has increased in the space of 15 months from 17.1x prospective earnings to 22.1x. That is why we say the market’s behaviour has introduced more risk. Diageo’s shares now trade in valuation territory which suggests the prospective return over the next ten years will be low.
Now, there are many other factors at play here, and other things could have changed to justify Diageo’s share price rise. Perhaps it’s forecast growth rate has increased – in which case, it could grow into that valuation in the years ahead. Indeed, according to Bloomberg Diageo’s anticipated earnings growth rate has improved from about 4% per annum in mid 2016, to about 10% per annum now. So the investment community, it would appear, has become considerably more upbeat about Diageo’s future growth prospects. Perhaps it will grow at 10% per annum over the next few years – in which case its current valuation is almost justifiable. But perhaps it will continue to deliver growth of 3-4% going forward, as it has done in the recent past. Either way, we have a situation here in which the starting valuation is high and expectations are high. In our view, that is not an attractive combination. We would rather invest in stocks where valuations are low and expectations are low – which is one of the reasons we remain attracted to the healthcare industry, and have grown increasingly attracted to UK domestic cyclicals in recent months (more on that another time…).
Turning back to the portfolio, the corollary to the market’s current obsession with China proxies, is that much of the rest of the market is out of favour and disappointing news, in particular, is being punished. Recent events at the AA can illustrate this. Its share price fell by -35% during the month. To warrant such a share price decline, one would perhaps have expected a pretty serious profit warning from the company. The trading update which prompted that share price fall, however, resulted in a 6% downgrade to this year’s earnings – disappointing therefore, but hardly catastrophic. Admittedly, there has been a series of earnings downgrades from AA since its IPO in 2014 and the news of the dismissal of its executive chairman, Bob Mackenzie, that accompanied the trading update won’t have helped, even though the dismissal does not disrupt the investment case. Indeed, some aspects of the trading update, such as membership numbers and cash generation, were encouraging. The shares’ disproportionate reaction just underscore how warped the market’s behaviour has become in recent weeks. From our perspective, the logical thing to do when shares are under pressure for non-fundamental reasons, is to add to the position, which is exactly what we have done with the AA.
Other UK-focused businesses such as Babcock International and Forterra also performed poorly in share price terms in August but it is difficult to explain why, other than that they do not fit with the current market zeitgeist. Indeed, domestically-focused stocks have remained deeply out-of-favour with the market over the course of the summer, which is one of the reasons we have become increasingly interested in them.
Some things in the portfolio did do well in August. Shares in Burford Capital continued to rise as investors digested the very strong set of interim results it had posted towards the end of July. Meanwhile, Hostelworld also posted a decent set of interim results, with strong growth in bookings across its online travel booking platform.
Hostelworld is an interesting case study to illustrate how fickle and short-term focused the market can be in the face of bad news. Regular readers may remember that this business suffered an operational setback in May last year which led to a significant decline in its share price. Our view at the time was that the trading disruption was caused by temporary factors and we maintained confidence in the long-term outlook. The share price fell by over 60% between April and June 2016 but, as trading has stabilised and recovered, the shares have since returned to new all-time highs. We employ a disciplined, fundamentally-based, long-term investment approach – this doesn’t mean we won’t make investment mistakes, but it does help us to avoid compounding those mistakes by selling at the wrong price when things don’t go according to plan.
In terms of portfolio activity, we have been keen to take advantage where possible of the market’s recent behaviour. As well as adding to the position in AA, we also took advantage of unjustified share price weakness in a range of other holdings, including British Land, IP Group and Lloyds. We also participated in the IPO of Strix, a manufacturer of kettle safety control products, which has come to the market at a very attractive price. Elsewhere, we took part in a fundraising by Horizon Discovery which completed during August, to finance its recent acquisition of Dharmacon from GE, which further strengthens its position as a leading service provider in the exciting and fast-evolving field of gene-editing.
These additions were financed by the sale of the portfolio’s holding in AbbVie. This is still a high quality business which we believe to be undervalued, but it has performed well for us in recent weeks and is no longer as attractive, in our view, as other investment opportunities to which we wish to have greater exposure. Similarly, the positions in Capita and Legal & General were slightly reduced.
Although the portfolio’s performance has been disappointing in recent months, we retain absolute conviction in the investment strategy. As Neil mentioned in the video, short-term underperformance is painful to endure, but our response to it is to continuously retest our investment hypothesis. In doing so, we conclude that our strategy is very appropriate for the current investment context. We do not believe that the rate of credit growth that we have recently seen in the Chinese economy is healthy or sustainable – neither, therefore, is the market’s response to it. It has taken the valuation stretch in markets to dangerous levels, and we believe that the portfolio is well placed to benefit when conditions begin to normalise. Undoubtedly, there will be further individual stock disappointments along the way, and it is likely that these will continue to attract more attention than the successes. But we are very confident that the successes will continue to outweigh the disappointments, allowing us to continue to deliver the excellent long-term performance that investors have come to expect from Neil Woodford over a very long period of time.
* We don’t mean to pick-on Diageo here – there are many other businesses which we could have used to effectively demonstrate the same phenomenon. We’ve chosen Diageo because it is a well-known business plus it also has the advantage of having a common currency for its share price and earnings forecasts, which isn’t always the case. All data in this case study is sourced from Bloomberg.
What are the risks?
The views expressed in this article are those of the author at the date of publication and not necessarily those of Woodford Investment Management LLP. The contents of this article are not intended as investment advice and will not be updated after publication.
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