FE Alpha Manager Neil Woodford has labelled performance of his £9.6bn CF Woodford Equity Income fund “disappointing” after it delivered a “modestly positive total return” in 2016.
The fund failed to beat the benchmark and sector average in 2016, delivering a total return of just 3.19 per cent last year.
“The fund delivered a modestly positive total return in 2016, but fell short of our aspiration to deliver high single-digit annualised returns to investors,” Woodford noted.
CF Woodford Equity Income vs benchmark & sector in 2016
Source: FE Analytics
The manager says while the fund was in positive territory during 2016 representing just one year in a multi-year strategy, it had not met its long-term aspiration for a variety of reasons.
However, Woodford says the fund had seen "considerable fundamental progress made across much of the portfolio which, given the prevailing market conditions, has not yet been reflected in share prices”.
“We have always been clear that the fund is very actively managed and at times, will not look or behave like the broader UK stock market – since launch, investors have seen the benefit of such an active approach but 2016 saw some of the fund’s prior outperformance unwind,” he said.
Woodford says much of the market behaviour in 2016 did not “appear to be grounded in fundamentals”, adding that in shorter periods sentiment and momentum can be bigger drivers of performance.
The FE Alpha Manager says market leadership had become “increasingly concentrated in a handful of stocks, most of them commodity-related”.
“Now you could argue that the performance of the oil & gas and mining sectors has been justified by fundamentals, given the increase that we have seen in commodity prices over the last twelve months,” he added.
“We are not convinced by that argument, however. Perhaps these sectors (and the commodity prices upon which they depend) fell further than they needed to in 2015 but the recovery since then, in our view, goes way beyond what fundamentals would justify, particularly when you consider that many key commodities remain structurally oversupplied and the global demand outlook is still very poor.”
FTSE All Share Oil & Gas vs FTSE All Share in 2016
Source: FE Analytics
Woodford says one example of the trend was FTSE 100 stock Royal Dutch Shell which rose by more than 50 per cent in 2016 despite consensus forecasts for earnings per share falling by around a third, which he says “the market clearly chose to ignore”.
“This is an extreme example and, obviously, Shell’s share price may have responded to many other things besides the outlook for earnings in 2016,” he said.
“Nevertheless, a similar pattern is evident across many other commodity-related stocks and, in aggregate, given the fund’s continued absence from these parts of the market, this has been the source of a significant part of the fund’s underperformance.”
Market leadership narrowed in 2016, says Woodford, rising by just 8.2 per cent when the six largest resource companies and HSBC were stripped out.
However, Woodford admits the fund failed to keep pace with the market without the index heavyweights.
“The fund’s performance has also been impacted by adverse share price performance from some parts of the portfolio – some of this is linked to negative fundamental developments but, importantly, much of it is not,” he said.
One stock highlighted by Woodford (pictured) was outsourcing service provider Capita, which halved during the course of the year following “a series of disappointing trading updates in the latter part of the year”.
“We have been disappointed and surprised by the apparent vulnerability of Capita to the weak trading in its more cyclical divisions (which are a small part of the overall business),” he said.
“The impact of this trading weakness has been exaggerated by a perception that, as profits have fallen, the company’s balance sheet has become stretched.”
Woodford says recent announcements by Capita management to dispose of its asset service division would help address balance sheet concerns.
“Furthermore, we believe the market has over-reacted to the series of profit warnings. In our view, the share price now profoundly undervalues the fundamental long-term attractions of this business.
“At times like this, it is essential that one does not compound the impact of a fundamental disappointment through an emotional reaction to a share price fall. We recognise that it will take time to rebuild credibility and value at Capita, but we are prepared to be patient.”
The manager says there were bright spots for the fund, including litigation finance business Burford Capital, which more than trebled in 2016. He also notes the strong performance of its tobacco holdings.
He also says the fund was maintaining its overweight in the healthcare sector, which had attractive fundamentals.
“The industry is becoming more incentivised to bring forward innovative treatments that address the heavy burden of healthcare costs on the economy,” he said.
“As a result, we see a lot of value being stored up in the sector and there are some very promising drugs coming through from the pipelines of both small biotech and large pharma companies.”
Woodford says 2017 could see some increased levels of M&A activity, adding that there is considerable long-term value in the sector.
He added: “In conclusion, despite the challenging market conditions we have witnessed and some surprising political events, nothing we saw last year persuades us that the portfolio should be positioned differently.”
“The narrow momentum-driven rally that we have seen has added risk to certain parts of the market. In particular we continue to avoid the oil & gas and mining sectors where, despite the rally in commodity prices, dividends are still vulnerable and the fundamental backdrop for prices remains weak. This positioning was unhelpful in 2016 but we’re convinced it’s still appropriate to avoid them.”
“Instead, the portfolio remains positioned towards attractively-valued businesses with significantly more control over their destiny.”
The approach, Woodford says, has delivered some considerable progress which will be reflected in share prices once fundamentals reassert themselves.