Why Morningstar Downgraded Woodford Equity Income

Morningstar analyst Peter Brunt explains to senior editor Holly Black why the Woodford Equity Income fund has been downgraded 

Holly Black 21 May, 2019 | 4:41PM
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Holly Black: Welcome to Morningstar's "Ask the Expert." I'm Holly Black and with me in the studio today is Morningstar Analyst Peter Brunt, and we're talking about the Woodford Equity Income Fund. 

Welcome to the studio. 

Peter Brunt: Hi, Holly. 

Black: So, you're joining us here today because the Woodford Equity Income Fund has just been downgraded from a Bronze to a Neutral rating. Can you tell us a bit more about what sparked that decision? 

Brunt: Sure. So, yeah, it's gone from Bronze to Neutral like you say. That follows on from last year when we downgraded it from Silver to Bronze. So, I guess, you could argue, it's just the continuation of our decreased conviction in the strategy. Why is that the case? The downgrade last year was because we felt uncomfortable with the way the portfolio was shifting and I guess that hasn't changed. It's continued in that direction. It's becoming far more focused on small and mid-caps. And I guess, the unquoted portion of the portfolio, which has always been something to keep an eye on, has become more prominent and I guess it's caused more problems for the way they are managing that portfolio. 

Why is that the case? I guess, because the quoted portion of the portfolio has been underperforming for a number of reasons including stock-specific problems but also the way it's positioned in terms of its positive stance on the UK economy. The unquoted portion has actually done quite well, but they've had persistent redemptions coming from that portfolio. So, as a result, they've been having to manage that including a number of actions that we don't normally see from fund managers. But as a result, the portfolio now looks really not as liquid as we'd like to see and it's probably the most illiquid portfolio that we have using our own internal liquidity analysis. So, we've just got to a stage where we find it hard to take a positive view anymore.

Black: But for the uninitiated, Morningstar ratings do include a negative rating and you've gone Neutral. So, presumably there are positive aspects there? 

Brunt: Yeah. I mean, it's a good point. So, Neutral means that we don't take a view on whether it's going to outperform or underperform the benchmark. Negative would imply that we think that it's definitely going to underperform the benchmark, that it's structurally challenged. And I think we are not at that point. I think we feel that there's potential unrealised value in the portfolio. Neil Woodford is still an incredibly experienced portfolio manager. But I think there's probably pressures on running that portfolio that we feel that is not able to do that the way he would like right now. And I think that's probably just taken away our conviction on the positive side. There's not enough there on the Negative to say that we think it's definitely going to underperform. I think there are still stocks in that portfolio that we're just waiting for the market to recognize the fundamentals.

Black: Do you think that we need a resolution on Brexit before this portfolio can perform?

Brunt: So, it's a good question, because that portfolio does have a significant exposure to the UK revenues. So, partially, yes, I think, is probably the honest answer. But I think the other side is that there are also a lot of idiosyncratic names in that portfolio that are not related to the UK economy. There are some biotech names; there are some general early-stage tech companies where actually it's not related to the UK economy and whatever happens in Brexit isn't going to affect their outlook. It's just the matter of the market hasn't been looking in that area for some time. And when those fundamentals are picked up, then perhaps that value will be released. So, it's not all about Brexit.

Black: But one thing, I think, you have to say for Woodford Investment Management is that they are so transparent. So, that portfolio might be illiquid and unusual, but it's published every month for everyone to see. They publish blogs to keep their investors up-to-date with what they are doing even in these more unusual steps they've taken lately. But is that kind of a blessing and a curse?

Brunt: So, it is. I think what we – we take a positive view and we certainly consider them leaders in the respect of disclosure and transparency. They brought fees internal way before anyone else – before MiFID II came into effect. As you mentioned, they are very transparent with their holdings and they are not afraid to defend their position which is more than most fund managers. It can work against you. And I think in this respect where, you know, it's a known fact that other market players have taken short positions in some of the names in that portfolio and I guess they have been helped by the fact that they are transparent and disclose their portfolio on a monthly basis before others. And I think, yes, it is a bit of a blessing and a curse. But we definitely commend more transparency and disclosure over less in general.

Black: Well, thank you very much for your time. 

Brunt: You're welcome.

Black: Thanks for joining us.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Holly Black  is Senior Editor, Morningstar.co.uk