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May was another month in which flows were more important than fundamentals. The sharp correction in the European bond market continued in the first half of the month, with the yield on the German 10-year Bund rising by around 70 basis points in just three weeks. We don’t think that this arose from expectations of a significant pick-up in the European economy or signs of inflation. Instead, it appears to have been largely due to speculative investors moving to exit a crowded trade.
There was, however, one striking fundamental development in the UK, where the general election confounded the opinion polls by delivering a majority for the Conservative Party on 7 May. The greater certainty entailed by a majority government led to relief rallies in the pound and the UK equity market early in the month. The result did not remove all of the political uncertainties that the UK faces, however. The overwhelming majority achieved in Scotland by the Scottish National Party leaves it with the third-largest representation in the House of Commons, but with no real power. This poses further questions about the viability of both the British constitution, the Union itself and the Conservative majority brings with it the pledge of a referendum on the UK’s membership of the European Union. More broadly, the outcome also underscores the unfairness of an electoral system in which the number of Westminster seats can be completely out of synch with a party’s share of the national vote. Nevertheless, much less benign outcomes were widely expected, and a more conclusive result is less concerning for the economy, albeit we continue to expect modest growth at best over the next few years.
The portfolio delivered a robust performance in absolute terms and relative to the FTSE All Share Index. Biotech and tobacco stocks were prominent in the list of top contributors to returns. The largest individual contribution came from 4D Pharma, which is making good progress with two new biotherapeutic treatments: Blautix, for irritable bowel syndrome, and Thetanix, for Crohn’s disease. During the month, the company announced that both drugs are moving towards first-in-man clinical studies, whilst it is also making good progress in other areas such as asthma and rheumatoid arthritis. Another biotech holding, Prothena, also made a significant contribution after UBS identified the company as a potential bid target, viewing its lead candidate, NEOD001 in AL amyloidosis, as an underappreciated asset.
Tobacco holdings Imperial Tobacco and Reynolds American both made strong contributions, after Reynolds’ acquisition of Lorillard finally received approval from the Federal Trade Commission in the US. The deal entails a major restructuring of the US tobacco industry, with Imperial Tobacco picking up a number of attractive brands spun off from both Reynolds and Lorillard.
Elsewhere in the portfolio, Capita and Babcock International performed well, having been under pressure in the run-up to the election. The election result installs what many expect to be a more outsourcing-friendly administration than other outcomes would have allowed.
Among the main detractors were GlaxoSmithKline and AstraZeneca. GlaxoSmithKline is a long-term holding and one which has been frustratingly disappointing for much of the holding period, both operationally and in share price terms. It is valued by the market as a struggling pharmaceuticals business – a view that we have some sympathy with because the pharma business has performed poorly operationally. However, in viewing it as such, the market is failing to appreciate the value of other parts of the Glaxo conglomerate. In particular, the current share price dramatically underappreciates the value of ViiV healthcare, Glaxo’s specialist HIV business. We continue to see considerable inherent value in Glaxo, however, and believe the sum of the parts to be significantly greater than the whole.
Meanwhile, although AstraZeneca has enjoyed a more favourable reception from investors recently, its shares declined in May after Amgen withdrew from its partnership with Astra to develop brodalumab, a psoriasis treatment. While this is disappointing, it doesn’t undermine an investment case which is supported by an excitingly diverse pipeline of potential new therapies.
Allied Minds weakened after a run of very strong recent performance. There is no fundamental concern here – rather, a large placing by another large shareholder caused a dip in the share price during the month.
In terms of portfolio activity, we added several new holdings to the portfolio during the month. We participated in a placing of shares in Horizon Discovery, a life sciences business which offers services to help translate the human genome and accelerate the discovery of personalised medicines. Norwegian technology business Idex also entered the portfolio during the month. The company is developing a unique and very promising in-glass fingerprint sensor solution which has enormous potential in the tablet & smartphone industry. We also introduced a small but extremely interesting position in Verseon, a US-based but UK-listed platform drug development business that applies a physics-based approach to drug discovery.
Elsewhere, we introduced pension platform business, AJ Bell, as an unquoted position. We have known the business for a number of years and we anticipate significant long-term growth opportunities ahead for the company as its market continues to evolve. Industrial Heat, which is building a portfolio of cold fusion technology capabilities, also joined the portfolio, as did Oxford Sciences Innovation, which represents a critical new link in Oxford’s science innovation infrastructure and an important part of the UK’s burgeoning technology commercialisation industry.
Amongst existing positions, we added to several core holdings including AstraZeneca, Centrica, GlaxoSmithKline and Legal & General. We added to Homeserve following a solid set of full year results and participated in a placing in IP Group shares.
Sanofi was sold from the portfolio during the month. This is still an attractive business operating in a fundamentally undervalued industry, but it is simply a casualty of the competition for capital in the portfolio. Its shares have bounced well since its operational disappointment in October last year, providing us with the opportunity to sell and reinvest in companies that we view as even more attractive in terms of long-term total return potential.
We also disposed of gas-to-liquid fuel technology business, Velocys. Although the company has some very impressive technology, our conviction in the company’s ability to fulfil its potential has diminished, as we now fear that other technologies may overtake it.
Looking forward, although some market participants are concerned about the impact of a continued bond market sell-off on equity markets and, in particular, equities with bond-like characteristics, we are not so worried. For a start, we do not expect a prolonged sell-off in bond markets – given the extreme valuations evident across much of the bond spectrum, that is ultimately inevitable, but the challenging global economic environment that we foresee doesn’t justify it any time soon. Perhaps more importantly though, there is a fundamental valuation attraction to every position in the portfolio, which, we believe, provides confidence in the prospect of positive long-term returns, regardless of how the bond markets, or indeed broader equity markets, behave.
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