The stock market sell-off that had started in September continued into the first half of October as the Federal Reserve neared the end of its QE program, economic data continued to disappoint and fears of deflationary pressures in Europe became more widespread. From its recent peak on 4 September, the FTSE All Share Index had declined by -11.8% by 16 October*, before staging a surprisingly rapid recovery towards the end of the month. Although the UK stock market appears well underpinned, particularly at the lower levels briefly visited during the middle of the month, we remain cautious about valuations across many parts of the market, and anticipate further volatility in the near term.
The portfolio is positioned cautiously and performed as one might expect in such a volatile market – generally outperforming its benchmark as it declined during the first half of the month, but then tending to lag its recovery. Our holdings in tobacco companies proved to be typically resolute and our healthcare exposure also performed relatively well. Meanwhile, our lack of exposure to the energy and materials sectors also assisted relative performance.
Nevertheless, some stock specific disappointments did take the shine off performance for the month as a whole. In these volatile conditions, the market is in no mood for disappointment and any company that fails to meet earnings expectations is being punished brutally. In particular, Rolls-Royce fell sharply following an unexpected and disappointing trading update.
Whilst the update from Rolls-Royce was unarguably disappointing, we were surprised to see the shares sell-off so aggressively. We took advantage of this by buying more shares. This is quite a normal reaction to disappointing news for our contrarian investment approach. Clearly, our reaction to a profit warning will depend on the exact circumstances and the extent of the market’s reaction, but we do often find ourselves buying into short-term weakness.
“The worst thing you can do is turn a disappointment into a disaster by reacting inappropriately. We often find ourselves reacting with a polar opposite response to the market on profit warnings. As long as we can retain confidence in the fundamental long-term investment case, we will take any panic selling as an opportunity to capture more long-term upside potential.” – Stephen Lamacraft, Fund Manager
Sanofi also suffered some savage selling following its third quarter results, which met expectations but the company’s comments about pricing pressure in its diabetes franchise alarmed the market and prompted downgrades to earnings expectations for next year and beyond. In retreating from €89.56 on 30 September 2014 to €73.66 by 31 October 2014**, the entire value of Sanofi’s diabetes franchise appears to have been wiped from the market cap. This seems somewhat harsh, particularly when one considers the diversity of Sanofi’s businesses, its pipeline of new potential products, its emerging market exposure which continues to grow strongly and its prodigious cash flow generation. Admittedly, the departure of the company’s chief executive just after the results statement added a degree of near-term uncertainty, but we continue to view the shares as profoundly undervalued and took advantage of the share price weakness by adding to our holding.
Elsewhere, BT delivered interim results broadly in line with expectations towards the end of the month but its share price declined due to a slowdown of growth in consumer broadband subscriptions. Capita also saw a sharp and, in our view unjustified, fall in its share price as it failed to win any of the Probation Services outsourcing contracts recently tendered by the Department of Justice. In both cases, we took advantage of short-term weakness by adding to our positions and continue to view the long-term outlook for the shares very positively.
Babcock International, an engineering outsourcing business, was added to the portfolio during the month. We have been attracted to the business for some time and have been patiently waiting for an entry point. Over the course of this year, the shares have fallen from £13 in late February to trade as low as £10 briefly in the last few weeks***, returning the shares to more attractive valuation territory. As with most other UK outsourcing businesses, Babcock has a substantial forward order book, good earnings visibility through long-term contracts and looks well positioned to deliver sustainable long-term growth in shareholder returns.
Elsewhere, we also added four new unquoted positions in the form of early-stage healthcare technology companies Emba, Viamet & Stratified Medical, and semiconductor technology business Spin Transfer Technologies. Our portfolio of unquoted holdings now consists of positions in 10 companies and currently accounts for just over 5% of portfolio assets. We are very excited about the long-term growth potential that this part of the portfolio represents and intend to provide further details in the next few weeks via our blog.
October marked the end of the Federal Reserve’s third dose of Quantitative Easing (QE). While the Bank of Japan continues to pump liquidity into the system and the European Central Bank (ECB) would clearly like to join it, the scale of liquidity injections without the Fed is much diminished. The end of Fed QE has, in the past, prompted renewed volatility in asset prices and we would not be surprised to see the same happen again in the near term. We feel the portfolio is positioned appropriately for this eventuality and remain very confident about the portfolio’s long-term prospects.
* Source: Bloomberg on an intraday, capital return basis in UK sterling.
** Source: Bloomberg
*** Source: Bloomberg
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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The views and opinions contained herein are third party and may not necessarily represent views expressed or reflected by Willis Owen.