Woodford Equity Income now owns 9% of Woodford Patient Capital, but its large weighting to unquoted stocks raises question marks over whether it can still be labelled as an income fund, writes Andrew Pitts.
Over the past three years to 11 March, investors in Neil Woodford’s flagship LF Woodford UK Equity Income fund (WEIF) have suffered losses of 6%, punctuated by a particularly poor 2018, when the fund was down 16.4%. In contrast, the average UK equity income fund has gained 20% over three years. Many of Woodford’s erstwhile fans have voted with their feet: poor performance and investor redemptions have seen its assets more than halve from £10.2 billion in May 2017 to £4.8 billion at end January.
Woodford himself remains bullish: “There have been very few occasions over the last 30 years when I have felt more positive about the outlook for the funds I manage,” according to the firm’s website.
Woodford Investment Management claims that the steep fall in assets is unconnected to the transfer of five of the flagship income fund’s unlisted companies, valued at £72.9 million, to Woodford Patient Capital investment trust (WPCT). Overall the trust now has a portfolio exposure of 14.1% to these five companies, up from 7.2%.
WEIF now also has a stake in WPCT, via new shares issued at net asset value, to account for the acquisitions as well as additional capital to meet further future investment that is expected to be required by these five companies over the next five years. The transaction means that the income fund now owns 9% of WPCT, while the latter now represents an estimated 1.4% of WEIF’s assets.
While some may raise valid questions of corporate governance standards surrounding this cosy, intra-familial transfer of assets, the immediate question is whether it represents a good deal for holders in the income fund. Well, overall the fund saw an immediate hit of around 13%, or just under £10 million, which was the discount on the shares at the time.
Will the discount on the trust meaningfully reduce? I think it unlikely – the vast majority of private equity-style trusts such as WPCT rarely trade at discounts to NAV of less than 10%, while discounts of 40%-plus have not been uncommon in periods of extremely poor investment sentiment and market stress.
What is arguably of more concern for investors in WEIF is how the two portfolios compare. The income fund continues to hold a very large slug of unquoted investments, valued at around £770 million, 16% of its value. However, analysis by stockbroker Stifel shows a worryingly high correlation, with unquoted stocks and early-stage growth companies in WPCT also representing 28% of WEIF’s portfolio. This raises a few more questions, not least whether a 28% exposure to unquoted and early-stage growth companies in an income fund is what retail investors expect.
While it is well-known that Neil Woodford has a long-held penchant for backing such companies in the income funds he has run, most successfully when he worked for Invesco Perpetual, some investors will find this level of exposure discomforting. Others with a higher-risk mindset might like the security of a 3.5% income with potentially higher growth prospects from the early-stage companies in the portfolio.
Investors in the income fund have much riding on the success of six early-stage companies that account for 15% of assets. These are the unlisted Benevolent AI (4.0% of assets), Oxford Nanopore and Industrial Heat (both at 2.3%); and the listed Autolus (2.6% of assets), Purplebricks (2.2%) and Prothena (1.5%).
However, the stark fact of the matter is that WEIF’s exposure to such companies was, in aggregate, far more appropriate to an income fund which had more than £10 billion in assets barely 18 months ago, than to one that has shrunk to £4.8 billion.
Investors in WEIF need to weigh up whether they are comfortable with this asset mix, and also factor in a potential scenario where performance continues to falter and the asset value continues to fall, with the commensurate risk that the fund increasingly exhibits fewer income characteristics and looks more and more like a growth fund unless the early-stage companies are sold.
I would not be surprised if that asset mix is already worrying financial advisers with clients whose UK equity income diet should be served in one predominant flavour – plain vanilla. The same concerns might also be exercising certain retail investment platforms that continue to push LF Woodford Equity Income to clients on the grounds that they still have faith in the strategy, or that clients won’t find a cheaper version elsewhere.
Andrew Pitts is associate editor of Money Observer. He edited the title from 1998 to 2015.