Neil Woodford on how he invests
At the Duff & Phelps annual alternative investments conference in London this week, Neil Woodford, the head of investment at CF Woodward Equity Income, was interviewed by Mathias Schumacher, the managing director of the London office of Duff & Phelps. He made a number of interesting observations, which are itemised below.
- World economic conditions are not benign, with structural issues in developed economies affecting emerging markets.
- Financial asset prices are artificially inflated by official policies, but it is hard to have confidence in the mechanism by which this is supposed to positively impact the real economy, while the risk it creates is starkly evident.
- A correction is inevitable. Over the next three to five years financial asset prices need to realign themselves with the "mundane reality" of the real economy.
- However, there are still under-valued anomalies to be found in the equity markets and, since the three to five year performance of an equity funds is bound to be volatile, it is a period in which active equity managers will "earn their corn" and prove that the apparently successful passive strategies of the recent past were an illusion created by loose monetary policies.
- If the proposed referendum on British membership of the European Union (EU) ends in a "Brexit" the adverse consequences will fall mainly on international banks and inward direct investors to the United Kingdom, such as the Japanese car manufacturers, since the main risk (currency) is already priced into stocks by virtue of the fact that the United Kingdom is in the EU but outside the euro.
- Stock markets have historically under- valued research and development (R&D) by seeing it as a pure expense rather than an investment, and preferring to buy products "on market" rather than in prospect, which means many managers miss attractive new product “pipelines.”
- Valuation is an art rather than a science, but is sold as a science in order to justify lavish fee structures; what matters in valuation is judgment about the future not the past; trust your instincts; recognise that valuation is necessarily dynamic because real economies are dynamic; and avoid setting "triggers" for selling stocks.
- What matters in an uncertain world is the dependability of earnings.
- Mergers and acquisitions look like performance boosters, but actually create reinvestment risk, and sit uncomfortably with long term investors, who tend to reach conclusions about corporate transactions that differ from those of shorter term competitors.
- Early stage businesses, especially those armed with disruptive technologies, are like “partly paid” investments, since even those not in the pre-revenue stage are bound to need more capital, and the capital will cost more because they offer higher returns, but they are akin to “partnerships” which should lead eventually to out-sized returns.
- It is best avoid investments where you do not understand the business model, such as Apple, Facebook and Google.
- Avoiding the Royal Mail IPO was “the wrong call,” based on a belief that the core business was declining, but the cash flow is strong and the asset base under-valued, and the share price has since fallen to a level not unadjacent to the flotation price, so the CF Woodford fund is now building a position.
- The fund sold £700 million in Tesco three years ago (to Warren Buffett as it turned out) on grounds structural problems were accentuating cyclical vulnerabilities, and it would be difficult for the business to extract itself from that combination, and the current “accounting issue” had created a fog around the balance sheet, earnings and cash flows which made it hard to re-consider investing.
- If a business is going the wrong way, it is preferable to “engage” via the chairman and the non-executive directors rather than sell the stock – “voice over exit,” as the report from John Kay, of which he is a “big fan,” advised – because capital allocation is the core purpose of investors (and company managers) and the alternatives of being dubbed an “absentee landlord” or using the dangerous but powerful “megaphone” of issuing complaints through the press are very much the last resorts.