Most investors will be glad to see the back of January 2016, after the worst start to the year for global equity markets since the financial crisis. The UK market actually outperformed most of its global peers over the month, but still endured steep falls in the first half of the month before staging an unbalanced recovery.
The triggers for the decline are not entirely clear. The continued meltdown of the Shanghai and Shenzhen stock exchanges served to highlight the concerns about the slowing Chinese economy. The oil price continued to fall, with many analysts now concerned that any benefits from lower input costs are being more than offset by growing deflationary risk. Macroeconomic data tended to be a bit worse than expected and, after much anticipation last year, investors were finally able to digest the implications of the rate rise in the US. All of these factors probably played a part in the downturn, but we believe that it was driven as much by equity valuations as by anything else. Valuations have looked stretched in some parts of the market for a while, particularly in resource-related and industrial sectors, and the market seems to have taken the new year as an opportunity to acknowledge that the current challenging economic environment will weigh on corporate earnings and therefore justifies a higher risk premium.
As is so often the case when equity markets take a sharp move lower, however, the early part of the decline was largely indiscriminate. Furthermore, when markets recovered somewhat later in the month, the rally was similar in characteristic to the September/October 2015 market rotation, which was led by areas to which we have no exposure – resources, for example – at the expense of sectors where we have considerable exposure, such as pharmaceuticals and biotechnology.
The fund’s net asset value declined over the month, registering a weaker performance than the FTSE All Share Index which fell by 3.1%. Both of the largest detractors from the fund’s performance came from the US biotech sector. Prothena fell heavily despite the lack of any significant news over the month – the move was symptomatic of the extremely negative sentiment towards US biotech in recent weeks. In the case of Alkermes, the sector-wide declines were exacerbated by a negative update on its pipeline with two Phase III trials of a potential treatment for major depressive disorder failing to meet their primary endpoints. This does not represent an outright failure of the drug, however. A further trial is still underway, and the company retains some hope that it will be able to file the drug for approval from the FDA eventually. Nevertheless, the development is a clear disappointment. In both instances and elsewhere in the broader health care industry, we think that share price moves look greatly overdone.
Elsewhere in the portfolio, three financial holdings, Provident Financial, Legal & General and Allied Minds, also performed poorly. Again, in each instance, there was no company-specific news to justify the share price moves. Indeed, a trading update from Provident Financial confirmed that all of its businesses are trading well, albeit tighter credit controls in its Satsuma consumer credit division have slightly reduced the growth rate in new customer numbers. Despite this, the company confirmed that it expects to report full year results in line with expectations and we are encouraged by the company’s continued focus on credit quality.
In the case of Legal & General, the market appears to be increasingly nervous about its exposure to corporate bonds in an environment of deteriorating credit quality in that asset class. We are less concerned – Legal & General does hold a substantial portfolio of corporate bonds on its balance sheet but it has provisioned over £2bn against future losses. It experienced no bond defaults in the financial crisis and we expect a similarly robust performance from its high quality portfolio of corporate bond assets going forward, even in the tough environment that we foresee. We remain very positive on the prospect of consistent and attractive long-term dividend growth from Legal & General.
Allied Minds, meanwhile, continued to experience share price volatility in January, despite an absence of new news. The market appears to be struggling to place an appropriate value on this young technology business but we remain very confident that its management team can create significant long-term value by nurturing its existing portfolio of maturing technology businesses towards commercialisation, as well as identifying exciting new opportunities through its relationships with the best research institutions in the US.
More positively, Reynolds American delivered a robust performance. Its shares had ended a strong 2015 on an uncharacteristically weak note, but they rallied in January as the market’s bout of nervousness underscored the company’s dependable characteristics once again. Indeed, the tobacco sector as a whole performed well, with shares in Imperial Tobacco and Reynolds American ending the month at all-time highs, with British American Tobacco not far off its own highest close.
GlaxoSmithKline also avoided the rotational malaise that affected peers such as AstraZeneca and Roche, helped by a growing appreciation of the value of the sum of its parts. All four of Glaxo’s major component businesses could be FTSE 100 companies in their own right, and we strongly believe that any future break-up would unlock considerable shareholder value. BT and BAE Systems also bucked the wider market declines to post modest share price gains during the month.
In terms of portfolio activity, we participated in a placing by Non-Standard Finance which helps to finance its acquisition of Everyday Loans, a fast-growing consumer finance business that is benefiting from the absence of major banks from the unsecured lending market. We know the management of Non-Standard Finance well and are confident that there is considerable potential for Everyday Loans to deliver accelerated growth under its ownership.
Towards the end of the month, we participated in a funding round for one of Allied Minds’ portfolio companies, Federated Wireless, which is developing a cloud-based platform to enable the sharing of highly valuable and increasingly scarce mobile telecommunications spectrum.
Elsewhere, we sold the remainder of the holding in Royal Mail, which had been reduced in December. This is still an attractively valued business, in our view, but we are increasingly concerned about the regulatory environment and the ability of the company’s management team to retain the benefits of cost rationalisation and potential property disposals for its shareholders, rather than for other stakeholders such as staff and pensioners. We therefore sold the holding in favour of other opportunities in which we have more confidence and where share prices have become increasingly attractive in recent weeks.
This allowed us to take advantage of the negative sentiment in the US biotechnology sector to add to our holdings in AbbVie, Prothena, Alkermes and Theravance Biopharma. We also added to Next, G4S, Legal & General and Provident Financial on share price weakness. Meanwhile, we participated in the share placing of retail property developer NewRiver Retail, which raised capital to fund its current transaction and development pipeline.
Looking forward, we remain cautious on the global economic outlook and continue to see a difficult year ahead for risk assets. Nevertheless, we have built the portfolio in anticipation of these conditions and remain confident about the prospect of delivering attractively positive long-term returns to investors. If anything, given the start to the year that we have endured, this confidence has increased, with higher potential returns resulting from the lower starting position.
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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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