Skip to the content

Neil Woodford: The FTSE stocks and sectors you should avoid at all costs

09 February 2015

A combination of expensive valuations and challenging macro headwinds are increasing the likelihood of earnings disappointments in a number of popular areas.

By Joshua Ausden,

Editor, FE Trustnet

Tracker and closet-tracker funds should come with a health warning at the moment, according to star manager Neil Woodford, who highlights a number of popular sectors and stocks trading at “ridiculous” valuations.

Investors in FTSE All Share and FTSE 100 trackers have had a good time since the financial crisis. While active managers have edged it over three and five years, index returns of over 60 per cent over the latter period are not to be sniffed at.

However Woodford (pictured), who runs the £4.7bn CF Woodford Equity Income fund, says expensive companies are at serious risk if the global economic recovery loses momentum, as he expects.

“Closet-index and passive investors have been lulled into a false sense of security,” he said. “Passives have delivered great returns because of monetary policy. It has lifted all boats but from here it’s going to be much more difficult. Passives are pregnant with risk.”

The manager highlights integrated oil companies, namely Shell and BP, banks and miners as being among the riskiest areas of the FTSE 100.

According to FE data, more than 200 funds in the Investment Association universe hold both oil majors in their top-10 – many of them FTSE trackers such as HSBC FTSE 100 Index and Royal London UK All Share Tracker. Francis Brooke’s Trojan Income portfolio and Martin Walker’s Invesco Perpetual UK Growth and UK Aggressive funds are also on the list.

A number of managers have highlighted BHP Billiton and Rio Tinto as being attractive income plays at the moment in light of management’s greater focus on balancing the books and paying dividends, though Woodford says “it’s far too early” to get excited about valuations. More than 50 funds hold the former in their top-10, including HSBC Monthly Income.

More than three times as many hold Rio Tinto, including BlackRock UK Income and JOHCM UK Equity Income. F&C UK Equity Income holds both BHP and Rio in its top-10.

Performance of sectors and indices over 5yrs

   
Source: FE Analytics

It’s not only risky sectors that Woodford is cautious of: he highlights a number of high quality companies that he’d love to own but that are trading at close to all-highs.

“Whitbread is trading on 26 times earnings. Unilever is on 21 times with no earnings growth. Reckitt Benckiser, a stock I have owned for most of my career, is forecast to have no earnings growth for two years. These are ridiculous valuations.”

Reckitt Benckiser is currently trading on a forwards P/E ratio of 22.8 times, according to Bloomberg. Hugh Yarrow, tipped by some to be one of the hottest prospects in the IA UK Equity Income sector, holds the company in the top-10 of his Evenlode Income portfolio, along with over 40 other managers.

While in the past investors have looked beyond earnings disappointments because monetary policy has been so accommodating, Woodford says the end of quantitative easing in the UK could see this trend reverse.

“Earnings downgrades are a new dynamic worrying investors. There have been 170-plus downgrades in the FTSE 350 this year. There’s a lot more risk than we’ve been used to in terms of stock specific risk,” he said.

“We are now in an environment where it is critically important that companies don’t stand on landmines.”


Companies of course have their own challenges – most notably mining companies in light of plummeting commodity prices – but Woodford says a backdrop of low growth and high debt makes them even more susceptible to a correction.

“The world economy is in a difficult place and I believe it will get worse before it gets better,” he said. “There is still a belief there will be normalisation of world economic policy, but it is a very long way away.”

“Money printing has been deliberately targeted to inflate asset prices, but now these levels are distorted. It’s much more risky to invest now than it was three or four years ago. It’s created valuation risk that we haven’t seen for some time.”

“There’s a challenging macro backdrop and challenging valuations. It’s a difficult place to operate.”

Woodford believes the “secular stagnation” of the world economy will only end when debt comes down significantly. Given that China – long lauded for having a strong balance sheet – has seen its debt pile balloon since the financial crisis, the manager says this is highly unlikely.

Woodford says the potential for policy errors in the UK and US could be the catalyst of a correction. The most open general election for a generation adds extra risk to expensive companies, he argues, though he expects few investors will give it the attention it deserves.

“Investors are not very good at factoring in political risk, because it hasn’t been a problem for a very long time,” he said.

“There’s the potential that it will result in more volatility than we’ve seen in a long time. It could be that we don’t have an effective government”

Woodford’s “gut feel” is that Labour and UKIP will do worse than is currently forecast, while the Conservatives and SNP will do better than expected. He expects there will be a functioning government of some form, though wasn’t prepared to give a more specific prediction.

Pressed on exactly when there is likely to be a significant market correction, Woodford said expensive stocks and sectors could continue to rally for a long while yet. However, he says he’s more than happy to sacrifice further gains if it means protecting investors from downside risks.

“I was asked in 1999 if the market was stretched and 15 months later it had doubled,” he said.

“I get queasy about some of the rubbish I see written about equities. Many have lost a grip on reality. If it carries on it could make me look very silly, but my discipline won’t change.”

Woodford’s stellar long-term track record is built on protecting investors on the downside. FE data shows his Invesco Perpetual High Income fund delivered top quartile returns in the aftermath of the dot com bubble, as well as in 2008 and 2011.

Performance of fund 1995 – 2014



Source: FE Analytics

Woodford remains optimistic in his outlook for healthcare and tobacco, which he says are still attractively valued. Early-stage and unquoted businesses are also very much on his radar, which he spoke about in more detail in an FE Trustnet article last week. 

“As is always the case there are undervalued assets. There are plenty of opportunities to exploit, but the opportunity set is much more stunted than it was,” he said. “I invest on a three to five-year view and I’m confident I can deliver high single-digit returns.”

CF Woodford Equity Income has had a great start since it was launched back in June last year. Returns of 11.34 per cent put it only behind Majedie UK Income in the IA UK Equity Income sector, according to FE data.


Performance of fund, sector and index since June 2014



Source: FE Analytics

Over the same period, the FTSE All Share has returned 2.26 per cent with more volatility. If Woodford’s fears turn out to be realised, however, things could be about to get a lot worse for the index.

He adds that some areas of the biotech sector – particularly in the US – is in bubble territory. Unsurprisingly he’s confident about the outlook of the three US biotech companies he holds in CF Woodford Equity Income and says he’s got plenty more lined up for his soon-to-be launched Woodford Patient Capital investment trust

Woodford isn’t the only one currently bearish on valuations in the UK. James Sullivan and Martin Gray, who recently launched three multi-asset funds at new venture Coram Asset Management, are more cautious than ever. 

“The fourth quarter of last year was the worst for six years in terms of profit warnings in the UK. There were 90 overall,” said Sullivan.

“It seems to us like there is a big disconnect between earnings and valuations. We’ve of course been saying that for a long time, but it now feels really risky out there.” 


ALT_TAG

Editor's Picks

Loading...

Videos from BNY Mellon Investment Management

Loading...

Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.