This article is part of Morningstar's Guide to Investing for Income
Neil Woodford is one of the best-known fund managers in the UK. Even my grandmother has heard of Woodford, though her risk-averse nature keeps in low-yielding cash savings accounts.
As Warren Buffett says: Our favourite holding period is forever
When he announced he was quitting Invesco Perpetual last October, outflows from his two equity income funds began immediately – despite the fact that he remained at the helm until March this year.
Fast forward nine months later and Woodford’s eponymous fund has already taken £2.2 billion in the first four weeks.
Investors saw their cash multiply more than ten times over two decades of Woodford’s tenure at Invesco, but the ride was not smooth. Those who deposited cash in the summer of 2007 would have seen losses of 60% 18 months later – although they would have made back their money by July 2011.
Woodford’s new Equity Income fund has similar holdings to his funds at Invesco, as his full holdings data released last week revealed. Alongside pharmaceutical stocks and tobacco companies Woodford has pepped up the portfolio with small Oxford-based science businesses, based within a short drive from Woodford Fund’s base in the same county.
We asked Woodford about the stocks in his new fund, and why he had chosen to buy up so many of his old favourites, despite a rise in stock prices.
More than 30% of the portfolio is invested in pharmaceuticals, why do you consider the sector so compelling and what differentiates these stocks?
Our exposure to the pharmaceuticals sector can be split into two types of company: large, mature, diversified pharmaceuticals companies such as AstraZeneca (AZN), GlaxoSmithKline (GSK) and Roche (ROG), and much smaller, earlier-stage biotech companies such as BTG and e-Therapeutics. The former group dominates the sector exposure but, while each business has its own specific attractions, the fundamental reason for owning all of them is the same – valuation.
I believe the market has forgotten that pharmaceutical and biotech companies are in the business of researching and developing new clinical therapies. They create future value by doing so. Essentially, over the past 15 years, the market has slowly started to treat the huge amounts of cash that these businesses spend on research & development as a cost, rather than an investment. In so doing, the market effectively assumes that there is no future value to imply in share prices. In other words, there is nothing in the price for the new drugs pipeline.
I believe this is a creating a significant valuation anomaly – valuations of the shares that I have invested in in this sector look attractive purely on the basis of the existing portfolios of therapies. However, when I factor in the prospect of even modest success from the pipeline, the valuation opportunity looks very compelling indeed.
I am convinced that the pharmaceuticals sector will prove to be a very rewarding home for investors capital over the next decade. Pharmaceuticals businesses are also not particularly sensitive to the prevailing economic backdrop, which is an added attraction in these challenging times.
The fund has only one minor oil and gas holding, why have you chosen not to invest in Shell (RDSB) or BP (BP.) when they are both yielding more than 4%?
Dividend sustainability is more important than dividend yield and I am not convinced that those paid by these businesses are sustainable in the long term. They are able to finance dividends by disposing of assets, rather than through operational cash flow, and this does not appear to be a sustainable strategy to me.
Some of the stocks have quite a low yield or no yield at all, will these be sold for capital growth or do you believe they will have dividend growth over the medium term?
Where we have invested in stocks with low yield or no yield at all, we would anticipate them delivering considerable income in the future as they mature and fulfil their potential. Such dividend growth should be matched by capital growth in the long term, but we don’t need to sell them to enjoy this capital growth. Indeed, as Warren Buffett says, “our favourite holding period is forever”.
The portfolio has four tobacco stocks – are you concerned about the unethical nature of these stocks?
The tobacco sector has performed incredibly well for a long period of time and I expect them to continue to perform dependably well, hence the continued exposure. I make investment decisions based on valuation and long-term fundamentals which in my view, continue to look really attractive in the tobacco sector. That doesn’t mean that I ignore moral or ethical issues – they are important to my investment approach but only insofar as I need to be assured that a company is conducting itself legally and appropriately. Not to do so poses a risk to future value.
At a dinner you recently hosted for financial journalists you championed technology and innovation – yet there are no pure play technology stocks in the portfolio. Why is that?
When I talk about technology, I’m not really talking about information technology – I’m talking principally about life sciences technology and environmental sciences technology. The UK has some of the best universities in the world, developing some of the best intellectual property. This technology needs nurturing and I believe that by investing with long-term, patient capital, can help these early-stage technology businesses fulfil their potential and add meaningfully to the long-term performance of the fund.
