The surprise outcome of the EU referendum triggered the much anticipated (and, in our view, ultimately inevitable) shock to sterling and sharp falls in stock markets across Europe. The UK currency fell to a 30-year low against the dollar, down more than 10% from pre-Brexit levels. In the equity market, the initial sell-off gave way to pronounced rotation, as investors fled from domestically exposed stocks to those with global revenues. This move was largely indiscriminate, at least regarding valuations, as many market participants appeared determined to make the switch at almost any cost.
Despite the extreme market reaction, we don’t think that the vote will change the overall trajectory of the economy. In the short term, the UK economy may slow a bit more than it otherwise would have done, but policy measures, both explicit (looser monetary and fiscal policy) and implicit (sterling devaluation), should mean recession is avoided. Both the UK and the world face far greater challenges than Brexit, with ebbing global growth, excessive debt, stagnant productivity, deteriorating demographics across developed economies and continued signs of a troublingly prolonged slowdown in China.
Accordingly, our investment strategy remains unchanged as we continue to be cautious on the outlook for the UK and indeed for the global economy. From a portfolio positioning perspective, however, the hysterical and valuation-insensitive behaviour that greeted the referendum outcome has led to a period of more rapid activity than is normally the case.
The fund’s net asset value declined modestly in June. Both of the largest detractors from the portfolio’s performance were in the financial sector: Legal & General (down more than 30% in the immediate aftermath of the Brexit vote) and Provident Financial (down more than 25%). As primarily UK-facing businesses, both of these companies have been bracketed with a group of other domestic cyclicals and financials, which a large number of investors have simply wanted to exclude from their portfolios, regardless of valuation or prospects. In our view, this is a mistake. We have spoken to the management of Legal & General and Provident Financial since the referendum and have concluded that both businesses remain well-placed to deliver very attractive rates of sustainable dividend growth in the years ahead. As such, we have been keen to take advantage of the ill-informed investor behaviour (essentially, panic!), that is a common characteristic of financial markets in a state of shock. We added to both holdings at highly distressed share price levels.
A similar phenomenon was evident, albeit to a lesser extent, in the share prices of several other UK-facing businesses that are held in the portfolio. For example, Babcock International, Capita and NewRiver Retail all suffered indiscriminate share price falls in the immediate aftermath of the referendum result which we exploited by adding to the positions.
The chart below shows a ridiculously short time period but it is useful in illustrating the extent of the rotation out of domestic cyclical sectors and into areas of the market famed for their dependability and global diversification.
Of course, our strategy is well-positioned to benefit from at least part of this rotation. The portfolio’s exposure to tobacco stocks made a significantly positive contribution to performance during the month, as did our exposure to major pharmaceutical companies such as AstraZeneca, GlaxoSmithKline, Roche and AbbVie. Indeed, such was the extent of the share price appreciation in some of these businesses, that we reduced the portfolio’s exposure to them, driven by the rapidly evolving valuation opportunity set in the market and our desire to exploit the distressed selling that had disturbed share prices elsewhere in the portfolio. This was particularly the case for Roche and Reynolds American, both of which remain attractive business but they both moved rapidly to all-time highs in sterling terms and have subsequently been substantially reduced.
Elsewhere in the portfolio, performance was held back by Circassia, which fell heavily after the company announced disappointing data for its high-profile vaccine for cat allergy sufferers. Although many aspects of the trial data were highly encouraging, further demonstrating the drug’s strong therapeutic benefits, the latest results also showed that a placebo had broadly the same impact on the symptoms. This is unprecedented and, thus far, inexplicable, but it does represent a material blow to the company’s allergy platform. We share the management team’s clear disappointment at this development but remain supportive shareholders. There is much more to Circassia these days than its allergy franchise, and the combination of its net cash and the value of its recent acquisitions suggests that the shares have fallen too far. It is, equally, far too early to conclude that there is no value in the allergy technology platform.
As well as the portfolio activity mentioned above, we also participated in two initial public offerings (IPOs). Draper Esprit, a leading venture capital investment company involved in the creation, funding and development of high-growth technology businesses with an evergreen, patient capital investment approach joined the portfolio. Meanwhile, Time Out, a media company with a well-known print operation was also added to the portfolio. This is a business with a strong brand and capable management team but the real growth opportunity is in digital media.
Mereo Biopharma also made its market debut during the month. We have been invested in Mereo, which specialises in acquiring and developing neglected mid-to-late-stage assets from major pharmaceutical companies, since July 2015 as an unquoted position. The portfolio benefited from a substantial uplift on the original investment and, albeit early days, the shares have traded positively since listing in early June.
All in all, it’s been a busier month than normal in terms of portfolio activity, as the valuation opportunity set rapidly evolved in the post-Brexit market environment. We have been compelled to sell some very attractive assets to take advantage of the indiscriminate selling of several shares. When the fight for capital intensifies in this way, the result is a stronger portfolio. With that comes an even greater level of conviction in the long-term returns that the fund can deliver over time.
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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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