Peter Sleep: How a passive manager spotted Woodford red flags in 2011

‘I have read that Woodford changed his style. I do not agree’

There is a theory that nominative determinism suggests that people gravitate towards jobs that fit their name. There may be some truth to this as am I am passive fund manager. How is it then that a passive manager spotted the red flags in Neil Woodford’s funds early on? The answer is a few basic due diligence steps and a bit of healthy scepticism.

When I meet an active portfolio manager I do not think “looking in the whites of their eyes” is useful. Some fund selectors may find this useful but I am a terrible judge. Clearly I meet the manager, but I prefer to look at their list of holdings which helps form a judgement.

I did precisely the same with Woodford in 2011 when he was at Invesco. I looked at his list of holdings and what I saw amazed me. The top 10 were pretty traditional Woodford income shares like tobacco stocks, big pharma and large telecom companies.  I thought the top 10 holdings were bold because it excluded many big index stocks – oils and resource companies, many of which were good dividend payers.

What was outside the top 10 caused me great concern though. I think I have a good idea about most of the companies in the FTSE 350, but I was surprised at the number of small companies and at the number of his unquoted companies. If you looked at the public factsheet for the fund there was no indication that any of his fund was unquoted.

Kryptonite to stock prices 

Looking at the companies themselves it quickly became clear that Woodford held very large positions in many medium and small companies, in many cases up to 30% of the issued share capital. These companies may have been listed, but the sheer size of the position rendered the companies illiquid. Additionally, some of the companies were not only pre-profits and pre-revenue, they were pre-business model. None of them had a place in an open ended income fund. Invesco is still working its way out of many of Woodford’s purchases, bearing out my observation.

When Woodford left Invesco and started his own firm he simply bought the same companies again, taking roughly 20% stakes in many of the same illiquid companies. He bought 30% in these companies at Invesco and 20% of these companies at his own firm. No wonder these stocks went up and no wonder his performance looked so good. Woodford managed £32bn at Invesco and £16bn at his own firm. The sheer weight of money going into the same stocks drove up their prices.

We all now know what happened when the money stopped flowing in and flowed out; the process reversed. When Woodford started selling his stakes, the hype went out of valuations and having Woodford on a shareholder register became Kryptonite to the stock price, compounding the underperformance of the fund.

Woodford’s undoing

I have read that Woodford changed his style. I do not agree. He may have latterly bought the housing stocks, but he generally held the same type of stocks. His undoing was when the outflows started and he sold down his most liquid stocks first leaving his fund with those illiquid large stakes I had first observed when he was at Invesco. The illiquidity of these stocks ultimately led to the fund suspension.

With the information systems we have at our fingertips a bit of due diligence on a manager’s portfolio is easy. Basic steps like checking what a company does, does it make money, its shareholder register and its liquidity are easy to find. You do not have to check every stock, a little bit of market awareness is all that is needed.

I have seen fund selectors pat themselves on the back for selling out of Woodford before his suspension, but for my money they should never have been invested in the first place had they done proper due diligence. Too many professional investors chased performance without thinking about freely available information that could have been found in Woodford’s annual report or his website. Unfortunately for us all the entire episode has undermined trust in the whole financial sector again, just as it was beginning to recover from the global financial crisis.

Invesco Income fund managed by Neil Woodford year end 2011

*Source 7IM, Bloomberg. Percentages shown are Invesco’s total holdings across all funds at year end 2011.  Only holdings greater than 15% are shown.

Peter Sleep is a senior portfolio manager at Seven Investment Management

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