Neil Woodford, who will renounce management of the portfolios in April, has had a long-running interest in both sectors, having bought into them when they were severely out of favour. Their subsequent success has helped create his reputation for making bold calls.
The tobacco sector has fallen out of favour again with investors recently, with worries over e-cigarettes, smuggling and regulation to the fore.
Meanwhile, pharma has had a good run and some investors are worried it is time to sell, but not FE Alpha Manager Barnett (pictured).
Performance of indices over 2yrs
Source: FE Analytics
“I own shares in a number of pharmaceutical companies, and tobacco, both UK and non-UK listed,” he said.
“In fact, in the pharmaceuticals sector, my biggest holdings are non-UK listed pharmaceutical companies, where I can own and have been able to own up to 20 per cent of my funds outside the UK.”
“Actually, in many respects, companies like Roche and Novartis are better businesses than their UK counterparts, albeit they might be more highly rated, so that’s something that I have to take into account. But as an overview, I do think the pharmaceuticals sector remains interesting.”
“The big picture is a very positive one: ageing populations in the West and increasing wealth in the emerging markets mean that the demand for their products is still very strong; and an FDA which now appears to be a lot less restrictive in terms of awarding licences to new products coming through.”
“There was a period 10 to 15 years ago where it appeared that the FDA was much more restrictive; I think that’s become less so.”
“And also the huge technology changes that are going on in the industry, driven primarily off the mapping of the human genome which occurred in the late 90s. It’s taken 10 to 15 years for the industry to evolve that and to create products which are driven off biological research rather than chemical research.”
“Biological research is where the entire industry is now moving and there is a lot of evidence that personalised medicine is going to be a big feature going forward, and that should play into the hands of the drug companies in terms of success from pipelines.”
“What we’re finding, of course, is that the stock market, having de-rated them substantially, has started to re-rate them, but is still only applying a pretty low probability of success to a lot of the pipeline products.”
“So, I would say that this is a combination which still looks attractive and I think the trajectory of pipeline success for these businesses is going to be a lot more positive over the next few years and, therefore, that would lead me to want to hold some big weightings in that.”
Healthcare is Barnett’s biggest sector bet in the £398m Invesco Perpetual UK Strategic Income fund, making up 21.11 per cent of the portfolio, marginally down from the 22.44 per cent at the start of last year. Roche, Novartis and Glaxo are top-10 holdings.
The manager holds tobacco companies BAT Group, Imperial Tobacco and Reynolds American in his top-10 – the second, fourth and 10th largest positions in the fund. They make up 11.95 per cent of the portfolio together.
“Tobacco: still very happy with the tobacco sector, notwithstanding the fact that there’s quite a lot of noise and mud being slung at it,” the manager said.
“There has been certainly, as we speak, and certainly in the last six to 12 months, partly as a result of the earlier point about the bond proxy-type argument: these are seen as the safest of the safe havens,” he added.
“And also, there’s a lot of nervousness about the e-cigarette market and how that’s going to change the picture for regular cigarette consumption, as well as plain packaging.”
“The fact of the matter is there are trends that have been working through the tobacco industry for a long while now.”
“There may be some markets where volume declines are faster than we’ve seen historically, but I don’t think the overall picture is necessarily more negative than we had this time last year.”
“The valuations of the companies are certainly a lot lower than they were last year; these businesses have been de-rated and, to a certain extent, they are vulnerable to emerging market currency weakness as well – particularly BAT, a very large business in the emerging world – but have the characteristics that I identified historically and I wanted to own historically: very strong cash generation, managements very aligned with shareholders, very substantial cash returns to shareholders.”
“Have those characteristics changed? No, they haven’t, and I think, at the moment, these companies offer quite substantial value in the market, and that would be an area that I have been increasing and would be increasing and would be interested to increase in the funds at the moment.”
Woodford has also long been famed for steering clear of the banks in the run-up to the financial crisis, and has stuck to that position since.
Some of the UK banks have seen strong share price recoveries in the past couple of years, with Lloyds expected to pay a dividend next year. However, scepticism on the sector is another attitude that Barnett shares.
Performance of stocks over 2yrs
Source: FE Analytics
“To me, the bank sector remains challenged,” he said. “Notwithstanding everything that they tell us about how the problems are behind us, only this week we had another announcement from the Royal Bank about more provisions for what I would call sins of the past, and they’re still working through quite a lot of issues with regard to the restructuring of that bank.”
“The big picture for banks, to me, is no loan growth, so top lines not really growing; they’re working hard on cost and, to a certain extent, they’ve improved their earnings performance because the impairment charges have come down significantly in the last 12 months.”
“The backdrop for banking, though, is, if you’re not growing your top line, in my mind it’s going to be difficult to continue to grow earnings; secondly, I worry about impairment charges picking up; and thirdly – and probably most importantly – the regulatory side continues to concern me.”
“Why? Because the regulators are being charged by the Government to ensure that these companies do not have to have recourse to public funds again, and that means that regulation in terms of capital requirements and the buffers that they need to put into the business, into the balance sheet, are probably going to go up.”
“This isn’t just the UK regulator: if you look at what’s happening in the US or in Hong Kong or in Switzerland; we’re about to see, later this year, the bank stress-tests in the eurozone.”
“The regulators are pointing in the same direction, which is tighter regulation over time, to the point where they feel that these banks are sufficiently capitalised.”
“We’re not there yet. The direction of travel is clear, and how long we take to get there is still unknown, but what I can say is I don’t think we’re there yet, so I would suggest that, over time, there is still regulatory pressure in the background on these organisations, and I don’t think that’s necessarily a great thing for the equity-holders.”
Barnett says that he prefers mid cap financials although his one large cap holding in the sector is insurer Legal & General.
He also holds a number of stocks in the non-life insurers: Hiscox, Beazley and Lancashire.
“They are exposed to different, uncorrelated risks – the catastrophe-insurance markets, which are completely uncorrelated to the wider economy – and they’re extremely well-managed businesses and offer quite attractive return on equity and profile of returns to shareholders, allied to which I’ve also had big positions in Legal & General, Provident Financial, the LSE, all of which are doing somewhat different things and are exposed to different parts of the financial-services industry,” he said.
“And also property companies, which is an area where I have had some holdings in some of the medium and smaller property companies historically.”
“And so, that’s gone to putting together quite a big financial weighting in my portfolio, albeit in areas which are in some of the smaller or medium-sized companies.”
Financials make up 20.59 per cent of the Invesco Perpetual UK Strategic Income fund, up from 15.46 per cent in January 2013.
Invesco Perpetual UK Strategic Income requires a minimum initial investment of £500 and has ongoing charges of 1.2 per cent.
Barnett recently told FE Trustnet about his expectations for the UK market in 2014.
