The “perverse” rally that has dominated equity markets over recent weeks has hurt the performance of the CF Woodford Equity Income fund and the Woodford Patient Capital Trust but manager Neil Woodford sees no reason for the “sharp and unbalanced” reversal in markets to affect their positioning.
After the strong falls over the summer, prompted by warnings of an economic slowdown in China and nervousness over the Federal Reserve’s future monetary policy, stock markets have ground higher over the past month or so with the FTSE All Share climbing 3.32 per cent over the past four weeks.
However, as the graph below shows, some sectors have performed far better than others; while the FTSE All Share Oil & Gas index is up 11.59 per cent, FTSE All Share Healthcare has fallen 0.51 per cent. In general, cyclical sectors have rebounded more strongly from the market falls while defensive areas have tended to lag.
Performance of indices over 1 month
Source: FE Analytics
One catalyst for the rally was the Fed’s decision to keep interest rates at their historic lows after the sharp fall in the Chinese stock market, while the weak US employment data that followed further diminished the likelihood of an imminent rate hike. However, Woodford Investment Management thinks this is poor reason for a rebound.
Mitchell Fraser-Jones, head of investment communications at the asset management house, said: “Fundamentally, the triggers for this sudden reversal are perverse. Why should the Fed’s decision not to tighten monetary policy due to ‘developments abroad’, followed by a weak set of US employment data prompt such a dramatic rotation into cyclical assets? From our perspective, the opposite would have been more appropriate.”
“There are some fundamental developments that may have contributed to the moves – a desire to believe that the worst of the China slowdown is now behind us, a weaker dollar and a growing political debate on drug pricing in the US are among them – but, in our view, these are less forceful than the negative macro developments.”
Because the rebound has concentrated on cyclical sectors (which Woodford’s funds have little exposure to) and has passed by defensive areas (which are some of the manager’s preferred hunting grounds), CF Woodford Equity Income and Woodford Patient Capital Trust have struggled to keep up in the recent rally.
FE Analytics shows CF Woodford Equity Income has been the worst performing member of the IA UK Equity Income sector over the past month after losing 1.06 per cent. Its average peer is up 1.84 per cent over this time. However, it’s still the highest returning member of the sector since launch in June 2014 after gaining 19.05 per cent.
Performance of fund vs sector and index over 1 month
Source: FE Analytics
Likewise, Woodford Patient Capital Trust is down 6.94 per cent in net asset value terms over the last month. In total return, it has shed 8.50 per cent and is ranked 15 out of 16 in the IT UK All Companies sector, where the average loss has been 0.76 per cent.
However, Fraser-Jones argues that the recent market rally could be down to ‘flows’ rather than being based on fundamentals, saying he believes the rotation is in large part the result of “investor positioning in over-crowded trades”.
“In recent months, many short-term market participants, such as hedge funds, have been flocking into the same popular positions to such an extent that the market became temporarily lopsided,” he explained.
“This appears to be an increasing feature of modern markets, now heavily influenced by high frequency trading, black-box quantitative models and speculative market participants. In the short term, these market participants can provide deeper market liquidity but they can also drive asset prices away from their fundamental value.”
The below graph shows the share price performance of the FTSE All Share Healthcare index relative to FTSE All Share Oil & Gas over the past five years. While it has outperformed over the bulk of the period, recent weeks have seen a sharp handing back of some of that outperformance.
Performance of fund vs sector and index over 1 month
Source: FE Analytics
Fraser-Jones adds that when healthcare’s earning per share performance is compared with energy’s, there is a similar level of outperformance – only it hasn’t come to an end in recent weeks. This suggests that the share price outperformance of recent years has had a strong fundamental underpin to it, he adds.
“Clearly, there is more to our strategy than healthcare stocks and the avoidance of energy exposure. However, this positioning has, until recently, been helpful to performance. Its success, though, has perhaps brought with it unintended consequences,” he said.
“Other investors appear to have recently joined this ‘trade’ simply because of the momentum. Momentum investing is diametrically opposed to the fundamental, valuation-oriented investment approach that we deploy. It means taking exposure to securities either physically or through derivatives in order to follow a particular trend, regardless of the price that you are being asked to pay for that exposure”
“For momentum investors, ‘the trend is your friend’. Or at least, it was. When momentum shows signs of reversing, a trend or ‘trade’ that had looked so appealing only a few days previously can suddenly look very perilous. Short-term market participants can flee at high speed, demonstrating a distinct lack of conviction in their positions. It is likely, in our view, that recent price action in markets has been driven by exactly this sort of behaviour.”
Despite the more turbulent recent performance of defensive sectors, Fraser-Jones says the Woodford funds still have “considerable conviction” in healthcare stocks for the structural growth stocks at play in the industry and their “attractive” valuations.
Healthcare is the largest sector weighing in the CF Woodford Equity Income fund, accounting for an overweight 32.90 per cent of assets (against the benchmark’s 8.52 per cent) through names such as AstraZeneca, GlaxoSmithKline and Roche. The portfolio has nothing in energy, even though it makes up 10.42 per cent of the index.
“We expect continued long-term fundamental outperformance of healthcare over energy, by virtue of continued and potentially accelerating growth from healthcare companies and the potential for continued earnings declines among energy companies,” Fraser-Jones said.
“So, although recent short-term performance has been challenging and uncomfortable, we remain convinced that our strategy remains highly appropriate and especially so for the prevailing economic conditions. The intense market rotation does seem to have lost a bit of steam in recent days, which is encouraging but what happens over the remainder of 2015 is anyone’s guess – that is why we invest for the long term.”
