Neil Woodford of Woodford Investment Management warns that the stock market rally of 2016 may have had more to do with momentum than fundamentals.
We have always been clear that our fund is very actively managed and, at times, will not look or behave like the broader UK stock market – over time, investors have seen the benefit of such an active approach but 2016 saw some of the fund’s prior outperformance unwind. That said, it’s worth spending some time looking at why the fund underperformed the broader FTSE All-Share Index in 2016.
Much of what we saw in 2016 does not appear to be grounded in fundamentals. In the long run, fundamentals are all that matters for share prices but, over shorter periods, they can be overtaken by other drivers, such as sentiment and momentum. That appears to have been the case in 2016 – market leadership has 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 12 months. 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.
Take Royal Dutch Shell. In sterling terms, the price of its B shares rose by more than 50% in 2016, presumably in response to the recovery in the oil price. However, despite the higher oil price, consensus forecasts for its earnings per share in 2016 declined by 34% as the year progressed. The market clearly chose to ignore these downgrades, and so its P/E ratio has now more than doubled from 12 times earnings to 27 times. 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. 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.
Adverse share price performance from some of our holdings has also played a part in the fund’s overall performance, however. Capita was a big position in the portfolio as we entered 2016 and its share price more than halved over the course of the year. A series of disappointing trading updates in the latter part of the year completely undermined market confidence in the business and, indeed, the credibility of management forecasts.
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). 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.
Management has announced the disposal of its asset services division, which should help to address these balance sheet concerns. Furthermore, we believe the market has overreacted 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.
There were some bright spots elsewhere in the portfolio. Our tobacco holdings delivered a positive contribution to performance for most of the year, although some of this was eroded in the final quarter as the momentum-driven market conditions intensified. Meanwhile, Drax also performed well as the market reassessed the progress it has made in transforming itself into a renewable energy company. Most of the energy that Drax now produces is made using compressed wood pellets rather than coal, allowing it to help the UK towards meeting its legally-binding carbon reduction targets in a cost-effective manner, whilst also helping to ensure security of supply by being able to provide power when it is required. No other renewable energy technology offers this combination of benefits.
We are often asked why we continue to be overweight in healthcare. It’s a sector that we believe offers investors an exceptional opportunity, not least because of its attractive fundamentals. The industry is becoming more incentivised to bring forward innovative treatments that address the heavy burden of healthcare costs on the economy. 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 – it is plausible that value starts to be recognised in the form of more M&A activity in 2017. Consequently, we believe that there is considerable long-term value within the healthcare sector and we have positioned the portfolio to capture this opportunity.
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.
Instead, the portfolio remains positioned towards attractively-valued businesses with significantly more control over their destiny. This control will ultimately be reflected in share prices, when fundamentals reassert themselves as the predominant influence of share price behaviour.
Neil Woodford of Woodford Investment Management is the manager of the St. James’s Place UK Equity, UK High Income and Income Distribution funds. The opinions expressed are those of Neil Woodford and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. Full advice should be taken to evaluate the risks, consequences and suitability of any prospective fund or investment. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.
Please be aware that past performance is not indicative of future performance. The value of an investment with St. James’s Place may fall as well as rise. You may get back less than you invested. Returns on equities cannot be guaranteed.