Investing personalities are often subjected to the age-old question: Is it skill or is it luck? From Warren Buffett to Neil Woodford, periods of underperformance often coincide with bad luck and harsh criticism regarding the alpha they can provide. In this regard, investing in valuation-driven, high conviction managers becomes more complex than it needs to be, as many investors pull out of a fund at the earliest sign of underperformance. Instead, we advocate investors maintain clear expectations and be prepared for certain periods of volatile performance.
In a recurring theme, the critics are back. Profit warnings among some of the more prominent UK companies have caught high-profile investors such as Neil Woodford off guard. One of the most distinct companies has been Provident Financial (PFG), which announced in August its second profit warning for 2017.
The subprime lender revealed further stress on its consumer credit division, which is now forecasted to post profit losses in 2017. Additionally, the company unveiled an FCA investigation on a repayment option plan product offered by the division. The stock price dropped 68% on that day.
Among the most affected by the stock price decline was the Woodford Equity Income fund, managed by Neil Woodford, which was holding slightly over 4% of the portfolio on the stock. Another stone on the road for Woodford, whose fund is having a difficult 2017 following a lackluster 2016.
Understanding Performance
To understand the poor performance at a more granular level, Provident is not the first profit warning to catch Woodford on the wrong foot. Back in July, AstraZeneca (AZN) shares plunged after its lung cancer drug failed a key trial. AstraZeneca is Woodford’s largest stock, representing 8% of the portfolio.
The manager’s responses after each announcement have been somewhat different, although each had a common undertone that focused on his core principles: adopting a valuation-driven and fundamental approach. In the case of AstraZeneca, the drug trial failure was already one of the scenarios he considered, and after discounting for value loss, he still perceived the stock as offering good value. The case of Provident Financial was somewhat different, as it was unexpected. Woodford reassessed his firm’s fundamental work on the stock, concluding that the stock still trades at very attractive valuation given its great potential.
Investors Start to Lose Faith
Some investors have been quick in their reaction, starting to question the fund manager because of this challenging period. However, they need to be wary not to fall into the trap of their own behavioural biases. The “hot hand fallacy” refers to the bias causing people to misinterpret random sequences. Originally termed by researchers at Stanford University in 1985, the “hot hand” refers to the belief that some basketball players experience momentum, causing them to have a greater chance of making successive shots after a successful shot. Empirical results proved otherwise, showing that probability within successive shots are uncorrelated.
The fallacy applies in a similar way to investing – and luck inevitably plays a role. A fund manager’s recent streak of unsuccessful stock picks might lead investors to underestimate the manager’s capabilities and assume that the manager will be likely to prolong his recent weak performance. A disciplined investor will avoid making such biased decisions, following a succession of positive or negative events, and instead focus on skill.
Taking a Long Term View
Over the last 12 months performance of the Woodford Equity Income fund has been poor – mostly due to a few of his largest exposures. The fund is lagging its benchmark by 14.6%, but this is not the first time the manager has experienced similar levels of relative underperformance during his career.
During Woodford’s tenure at Invesco, the manager experienced similar negative periods in 2000 and 2009. In early 2000, two of his highest conviction stocks fell sharply – British American Tobacco (BATS) and International Power, by 52% and 21% respectively; and the fund lagged its benchmark by 17.5% over 12 months. Nonetheless, a disciplined investor would have been greatly rewarded by sticking with Woodford as over the following five years the fund earned annualised returns of 12.4% vs -1.7% of its benchmark.
Perspective, Perspective, Perspective
It is useful to remember that Warren Buffett has come under immense pressure at many times over his career including famously during the 1999 tech boom. We know it is practically impossible to outperform during every period, so we must maintain a framework that assesses skill versus luck and captures the tenacity of the manager in question. Skilled managers have good and bad luck, just like unskilled ones.
When undertaking this analysis, it is useful to remember how easily humans fall in the trap of focusing on recent events. Investors need to try to overcome such short-term bias and focus on the larger picture – keeping turnover to a minimum and affirming conviction through periods of both good and bad luck.
