The UK stock market posted a small negative return during July. Having moved broadly sideways all year so far, the market took a nervous step downwards in the last couple of days of July in a move that has continued thus far into August. It isn’t a drastic move, in the context of some that we have seen in recent years, but equity markets have lacked volatility this year and a feeling of complacency appears to have crept into some parts of the market.
Source: Bloomberg in capital return terms to 4 August 2014.
We have been a bit surprised by the market’s lack of concern about some of the geopolitical events that have been brewing in the background – the unrest in Ukraine / Russia and Israel / Gaza, for example, initially shrugged off by the market, but in recent days the market seems to have become, quite rightly, a bit more concerned. These issues are not positive for an already troubled global economic outlook and do not look easy to resolve.
The fund reported a very slight increase in price during the month of July in contrast to the market’s slight decline. However, one month is a very short time period to be analysing a long-term investment strategy in an asset class that really needs to be judged in periods of years rather than months.
The fund’s performance was negatively impacted by a disappointing set of financial results from GlaxoSmithKline, the fund’s second biggest holding. In particular, a poor performance from its respiratory franchise, led to revenue, profit and earnings all declining and missing consensus expectations by some margin. It did, however, meet expectations with its dividend, announcing a 6% increase in its Q2 dividend of 19p per share. A long conversation with Glaxo’s Chief Executive post results has allowed us to maintain confidence in the long term investment case, despite this near term setback. Glaxo remains a very cash generative business and it is a very cheap share in our view, with a starting yield of 5.5%* and the prospect of modest but sustainable long-term dividend growth. We bought a few more Glaxo shares towards the end of the month.
The negative impact from GlaxoSmithKline was partly mitigated by better performance elsewhere in the portfolio. Capita, for instance, performed well buoyed by very strong financial results which showed double-digit growth in revenue, profit, earnings and dividends. HSBC also performed robustly on no news. A couple of our intellectual property commercialisation holdings also performed well during the month – Allied Minds and Imperial Innovations. The latter announced the successful IPO of one of its investments, Abzena, which raised £20m by issuing shares to new and existing shareholders, ourselves included, at 80p per share. Abzena is the fourth Imperial Innovations’ company to join the public market in recent months, demonstrating the strength in depth of its exciting and valuable portfolio.
The market greeted news of further consolidation in the tobacco sector somewhat negatively, which surprised us because we think it’s a great deal for all concerned. This is probably a case of it being better to travel than to arrive, however – the sector had a very strong run of performance in anticipation of the deal. Reynolds American, which has agreed to acquire Lorillard, was particularly weak but we think its good news for the company. It creates an opportunity for them to take a step forward in terms of scale, efficiency and brand portfolio strength. BAT also stands to benefit, being a 42% shareholder in Reynolds. The deal, if consummated, is expected to deliver a very attractive return on investment to Reynolds and enhance next year’s earnings by a mid-teens per cent.
The deal is also good news for Imperial Tobacco, which intends to buy some attractive brands that Reynolds / Lorillard need to sell for anti-trust reasons. This represents a great opportunity for Imperial Tobacco to improve the fortunes of its US business and, again, if consummated, is expected to deliver very attractive returns and earnings enhancements. This is a sector that has created considerable shareholder value through M&A in the past. Tobacco companies have done this by doing the right deals, at the right price, at the right time. We remain positive on the sector and bought more shares in each of the companies involved, focusing particularly on the opportunity to add to Imperial Tobacco and Reynolds American at the lower prices that prevailed after the deal had been announced. We did sell our holding in Altria though, which maintained the fund’s overall exposure to the sector at broadly the same level.
Elsewhere in terms of portfolio activity, we added several new holdings to the fund, the largest of which was Royal Mail. Since its IPO last year, the shares initially performed very strongly but have since come back to more attractive territory. This is fundamentally a very attractive, cash generative business. It has its challenges, not least the competitive threat in profitable, densely populated areas. But it has its opportunities too, such as slowly working to bring its cost base into line with its competitors. Royal Mail has an operating margin of 4.6% compared to 8-10% for most of its peers*. We have been impressed by the management team and believe it is well-placed to capitalise on the long-term opportunity to deliver a better service to its customers and generate sustainable shareholder value.
Other new holdings added during July included Oakley Capital, Raven Russia and we participated in the IPOs of Abzena (mentioned above) and Spire Healthcare. We increased exposure to several core holdings but Altria, Novartis and Serco exited the portfolio.
Our strategy and outlook for the fund remain unchanged. We see a challenging future for the global economy and indeed for equity markets in a world without artificial support from the Federal Reserve. Nevertheless, we have built the portfolio around attractively valued businesses that can deliver sustainable long-term growth in spite of the difficult economic environment. Hence, we are confident that the portfolio can, in turn, deliver attractively positive long-term returns.
* Source: Bloomberg as at 5 August 2014.
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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