Woodford’s closure, FTSE 100 valuations and The Property Chronicle

Unfortunately for his investors, Neil Woodford’s flagship fund is to be closed in the new year.

(Update: The entire Woodford empire is now closing down)

This is obviously terrible news as a lot of people could lose a lot of money.

I don’t want to trivialise this by jumping on the news-cycle bandwagon, although I guess that’s how this is going to look.

I saw a lot of “lessons from Woodford” articles across my news feed this morning, so I though I would apply the Tesco philosophy of “every little helps”, and re-publish an article I wrote a few weeks ago.

I wrote it for a new magazine called The Property Chronicle, published by those nice people at Harriman House (who also, not entirely uncoincidentally, publish my book).

Reading back through the article, I think two lessons are paramount (one of which I forgot to mention):

  1. Don’t borrow short and lend long (or in this case, don’t invest cash into assets that could take months to sell if you might need the cash back at short notice)
  2. Diversify, diversify, diversify (even if that means holding several funds which are themselves diversified)

Lessons from the fall of a superstar fund manager

FTSE 100 fair value could be close to 10,000

While I’m in the process of “repurposing” magazine articles into blog posts, here’s another one where I talk about the FTSE 100, its unusually high dividend yield and how its fair value could be as high as 10,000.

Obviously, there are no guarantees that the FTSE 100 will hit 10,000 anytime soon, but I do think 10,000 and beyond is the likely outcome at some point in the 2020s (and until then, the index’s 4.5% dividend yield is an attractive consolation prize).

Time to take profits on the FTSE 100?

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

23 thoughts on “Woodford’s closure, FTSE 100 valuations and The Property Chronicle”

  1. Hi John,

    Woodford previous outperformance was due to luck.

    In the late 90s he invested in excellent but old companies at significant discount because investors favoured tech stocks. and shunned old stocks. Therefore luck played a huge role.

    If I was Woodford I would have retired like Peter Lynch leaving on a high. The idea he could replicate the performance again was silly idea. Woodford was investing in extraordinary circumstances.

    I’m not being judgmental even Buffet was lucky when he opened his partnership and he knew it. This was the reason why he closed the partnership because he knew the opportunities were no longer there. A real pity Woodford doesn’t have this insight.

    1. Hi Rob

      Luck is always a factor, but I don’t think Woodford’s prior success was primarily down to luck. I think he did a good job for a very long time, helped by an environment and team at Invesco Perpetual, his old firm.

      The problems (including the just-announced closure of Woodford Investment Management) stem from the monumental error of holding illiquid assets in a highly liquid open-ended fund.

      Hopefully the FCA will update the rules on this to insist on a specific amount of liquidity in open-ended fund holdings.

      1. “”helped by an environment and team at Invesco Perpetual””

        I think that sums it up John.
        His open forum in his new company allowed people to comment on his web site. It was clear over the last few years that Neil Woodford didn’t have a clue what he was investing in. Sounds like a bold statement from a novice investor like myself, and rather a rude comment.

        But it isn’t and there are a number other factors other than investing in unquoted companies. It was clear that he and his team knew very little about evaluating the risks of the companies they invested in, otherwise they would not have done the following :-

        Invested a large % of the fund in biomedical companies that have a very low % chance of producing a revenue stream, let alone a profit. The failure rate was indeed astonishing and he kept making the same mistake. What was it Einstein said?
        Buying companies that have been offloaded by Private Equity Firms, which invariably meant they had very high debts. AA for example?
        Buying into very low margin cyclical companies like Capita etc
        Advertising his fund as Equity Income while continuing to invest in companies that did not provide an income and had no clear prospect of doing so. This will surely now open him up to investigation now the whole company has withdrawn from the three investment vehicles, losing thousands of people a lot of money.
        Not providing any rationale information to investors on how and why he invested in certain highly operationally geared companies – somewhat calling into question what the analaysis was if any.
        Holding too many investments — 120 or close to that number at the peak. It simpy isn’t possi ble to track them properly or efficiently with a small team.
        Lurching from crisis to crisis – buying and selling many investments.
        Continuing to take a fee from the fund after suspension – it did not hold much regard for the pain suffered by the investors.

        Some of these comments were put to the team in their monthly updates — eventually people who questioned these things, no names of course, were blocked from commenting. Not really that surprising I suppose.

        The Damage to the investment fund industry is probably immeasurable.

        But maybe it is time for people to wake up and invest in companies directly and take it as their own responsibility.

        I mean — why pay someone to lose money when one is perfectly capable of losing it themselves perhaps without the associated high fees?

      2. Hi LR

        Excellent points there. I have tended to give Woodford the benefit of the doubt, and even now I’m inclined to say that we don’t really know how things would have panned out over the next, say, five years if there hadn’t been a (self inflicted) run on his fund.

        But even I have to admit that his stocks did seem to have lots of problems, even given the not particularly rosy economic backdrop and being in the wrong style (value) at the wrong time (now).

        I think this will drive huge numbers of UK investors into passive funds, which is a good outcome if they’re globally diversified. I also think you’re right that it could provide a boost to the number of investors buying individual company shares directly rather than through funds.

        Or perhaps everyone will just forget this ever happened and the next generation of investors will say “Neil who?”

  2. I would make a further point and that is that when Woodford set up his company he had some ideological motivation, best summarised in the quote from WPCT prospectus:

    “The UK has some of the best universities in the world, developing some of the best intellectual property. Unfortunately, as an economy, the UK does not have a good track record at converting these great ideas into long-term commercial success. There are many reasons for this but the principal one, in the Portfolio Manager’s view, is a lack of appropriate capital.”

    There are some really big assumptions and some pretty significant arrogance behind these statements. I reckon Woodford lost the plot the moment he undertook this mission to correct this wrong.

    The real world rarely fits with ideological models and is best avoided in business and politics.

    1. Hi George, that’s a very good point.

      I don’t have an opinion on the rightness or wrongness of his wanting to fix a perceived capital allocation problem. But clearly an open-ended fund was the wrong vehicle for this mission. His unquoted investments should have been in the patient capital trust and only in the patient capital trust.

      It’s a shame things had to get this bad for that lesson to be learned, but hopefully the regulator will close the obvious loopholes in this area.

  3. Hi John,

    Thanks for another great article on the FTSE-100 valuation.

    One comment the bears might make is that the dividend is not well covered by earnings and so may not be sustainable.

    Do you have any data for the dividend cover in 1999 and 2019? I often look for this metric and never seem to find it!

    Best wishes
    Jon.

    1. Hi Jon, dividend cover isn’t too horrible at the moment. It did fall below 1.0 a year or so ago, but earnings have rebounded and today (or recently) it’s at 1.5.

      That’s with the FTSE 100 = 7426, PE = 14.9 and yield at 4.35%. These aren’t quite the latest figures but you can get those from the FT ‘global world markets at a glance’ report:

      http://markets.ft.com/Research/Markets/DataArchiveFetchReport?Category=&Type=GWSM

      The average since the mid-80s is 1.9% using yearly data, so we’re a little below that but nothing that suggests the FTSE 100’s dividend is going to be cut significantly.

      Also, if you look at the FTSE 100 dividend over the long haul there have been no prolonged cuts. Just a one-year cut in the 1992 recession, another one in the 2000 slowdown, a three year decline in the 2008-2010 period (falling 9%) and a very minor blip in 2014. Other than that it’s headed upwards every year at about 2% ahead of inflation.

      And 1999 dividend cover was about 1.7 to 1.9 depending on the date.

  4. Re FTSE 100 article:

    I was hoping to see the formula for calculation of fair value. Or, at least the discount rate.

    Also, there is a discussion of 2% dividend yield in 1999 versus 4.3% in 2019.

    How do we incorporate the information that interest rates were %5 in 1999 and 1% in 2019?

    So we had 2% yield when saving account interest was 5%.
    Now we have 4.3% yield when savings earn 1%.

    1. Hi Ken, sorry for the lack of detail. It was a fairly short article because of a space/word limit imposed by the magazine.

      There are lots of different ways to work out fair value, and in this case I was using the dividend discount model, which is:

      dividend / (require rate of return – estimated dividend growth rate)

      The FTSE 100 dividend is about 330 index points (FTSE 100 price of 7,150 * 4.6% yield).

      I used a required rate of return of 9% based on an average historic dividend yield of 3.3% and an average dividend growth rate of 6% since 1985.

      I used an estimated dividend growth rate of 6% because that’s been the dividend growth rate since 1985.

      Therefore:

      ‘fair value’ = 330 * (9% – 6%) = 11,000.

      I used slightly different numbers for the article (318 dividend, 9.3% expected growth) and came up with a fair value of 9,750. This shows how sensitive these estimates can be to changes in the input values.

      However, my point was that by using fairly reasonable estimates for growth and expected returns, it’s possible to get a fair value figure of around 10,000 or more.

      To get a fair value of around 7200 (close to today’s value) we could estimate that investors require a total return on 8.6% rather than 9%, and that the dividend will grow by 4% forever (about 2% above the BoE inflation target, which might be reasonable).

      So it seems that investors are, in aggregate, expecting low inflation and relatively low growth forever, which may be right but then again it may not. History suggests that when (if) the economy starts booming again, investors will ramp up their expectations for growth and that could see estimates of fair value far above 10,000 within the next decade.

      As for interest rates, it’s an interesting point. Dividends grow over time and interest payments don’t, so it would be reasonable to expect dividend yields to be lower than interest rates on savings accounts because dividends will grow in future and the interest payments won’t. But then again, equity investments are far riskier than savings accounts, so that risk has an impact on the price investors will pay and the dividend they will demand. So there is obviously a relationship between dividend yields and saving account interest rates, but I think it’s a pretty loose one most of the time.

      1. ‘fair value’ = 330 * (9% – 6%) = 11,000

        I think the multiplication is meant to be division, as per

        dividend / (require rate of return – estimated dividend growth rate)

      2. Thanks Ken, yes that’s a typo. It’s basically the Gordon Growth Model which is:

        Present value = next year's income / (discount rate - growth rate)

  5. Hi John,

    I think luck played an important part in Woodfords success because his biggest wins were investing in tobacco stocks in the late 90s where the share price completely plummeted due to MSA and Mr Market being pessimistic and misunderstanding. This was circumstantial. Nothing wrong with that but the idea to mistake that with talent is not the wisest thing to do. Similarly he got off the bank shares before the financial crisis again I believe this was entirely luck because if Woodford knew of an imminent financial crisis logically he should have divested his holdings and held cash to buy stocks during the bear market.

    I have made my own mistakes for example I invested in AA but my philosophy has changed significantly on reflection.

    I now look for company with high profit margin, significant scale which makes it impossible for a competitor to enter the market, healthy cash flow, high ROE, leverage that can be easily paid if necessary, good capital allocation opportunity, low capital expenditure, remuneration is linked to the long term performance of the company and most importantly management who are shareholder friendly.

    Sadly AA fits none of these criteria. If I go back to Woodford as LR noted he went for unquoted companies where its impossible to assess companies against the criteria’s I have listed. Buffett is known to have purchased unquoted companies but unlike Woodford’s holding these were SME which have been established for years and generate plenty of cash.

    To me it also seems Woodford was speculating and not using value investing. Typically value investing involves either the process of physically evaluating the value of the tangible assets and value is realised when you liquidate the assets (Graham version of value investing) whilst value investing as a going concern is relying on the company being able to compound earnings over a time period that exceeds initial cost (Buffett style). If one was to look at Woodford it becomes clear his selection of stocks fail to fit in either category.

    I look at Woodford’s failure not to glee but learn what to avoid myself. I personally believe that its easy to grasp the concept of good investing behaviour but it requires luck to be presented with the opportunity (after all we are asking Mr Market devalue a priceless company to junk bond status )and to have the patience to wait for that opportunity.

  6. Hi John

    I’m interested in the background to the ‘dividend yield plus dividend growth’ model? Is it based on empirical evidence only or is there some underlying link between the rate of dividend growth and the capital growth that actually delivers the return on investment ( as well as the dividend itself of course)

    Thanks

    Steve

    1. Hi Steve,

      The yield plus growth model is mathematical rather than empirical, but for stable companies or indices like the FTSE 100 it’s a useful measuring stick.

      Basically, the return on any investment is the sum of income (e.g. dividends) plus capital growth or loss. With equities, both income and capital growth/loss can be variable, so the “yield plus growth” makes the simplifying assumption that dividend growth and capital growth are the same, which means the dividend yield stays the same.

      For example: A share is 100p today and has a yield of 5% based on last year’s dividend of 5p.

      If during the next year that share pays out a dividend of 5.5p, the dividend has grown by 10%. If the yield is still 5% a year from now then the share price must be 110p which means the share price has also grown by 10%.

      So:

      total return = dividend income + capital growth

      capital growth = dividend growth (our simplifying assumption)

      therefore:

      total return = dividend income + dividend growth

      Of course, the dividend yield almost never stays the same and capital growth almost never equals dividend growth, but it’s still a very useful assumption.

      If you want, you can always work out what the price would be if the yield changes using this formula:

      FP = CP * DG * (CY / FY)

      where:

      FP = Future Price
      CP = Current Price
      DG = Dividend Growth (over the entire period, plus 100% so 10% dividend growth should be input as 110%)
      CY = Current Yield
      FY = Future Yield (an estimate of the future yield)

      So if we’re looking at the FTSE 100, we can work out what the FTSE 100’s price would be with certain dividend yield and growth assumptions.

      Let’s say it’s 1999 and the FTSE 100 is at 7000 and its yield is 2%. Let’s assume the dividend doubles over the 20 years to 2020 because of inflation and economic growth. Let’s also assume the yield halves:

      FP = 7000 * 200% * (2% / 4%) = 7000

      This is basically what happened over the last 20 years. The FTSE 100’s dividend (more than) doubled, but so did the yield so the price went nowhere.

      There’s a website called the Corporate Finance Institute which has a lot of short articles about this sort of thing, e.g.

      https://corporatefinanceinstitute.com/resources/knowledge/valuation/gordon-growth-model/

      1. Hi John

        Thanks for the explanation. The part I was looking for evidence for is “the simplifying assumption that dividend growth and capital growth are the same, which means the dividend yield stays the same.”

        I can see how it simplifies things but has it ever been tested to see if it’s reasonably true in real life? As you say “the dividend yield almost never stays the same and capital growth almost never equals dividend growth,” in which case it may be convenient but wrong! In which case, what’s the point in using a convenient but wrong assumption?

        Regards

        Steve

      2. In the stock market, growth and yield are always uncertain, so yes, the yield plus growth model is a tool for estimating future returns. The question then is how uncertain is growth and yield.

        If yield and growth are highly uncertain then the yield plus growth model probably aren’t appropriate. But if you’re using it to estimate future returns from a major index (FTSE 100, S&P 500 etc) or a very stable company (Unilever, Next, etc) then I think it’s a useful tool because yield and growth for those entities is usually quite stable.

        For example, if Unilever has grown by about 5% per year over the last decade, then that is perhaps a reasonable ballpark assumption of future growth. And if its yield has averaged 3% over the last decade, and is 3% today, then perhaps it’s reasonable to assume that it will be 3% a decade from now. And in that case, it’s reasonable to assume that Unilever will (in this hypothetical example) return about 8% (5% + 3%) annualised over the next decade.

        Obviously this is an estimate, and obviously it will be wrong, but it’s still useful.

        Here’s another example. In 1999 the FTSE 100 had a historic dividend growth rate of about 6% and a dividend yield of 2%. If investors assumed both those would stay intact forever then they would assume forward returns of 8% per year. The reality is that they didn’t get this return because the assumption of a 2% yield wasn’t reasonable as 2% was far below the index’s average yield of 3%, or thereabouts. So the yield reverted to its mean, and in fact went above its mean to more than 4% today.

        So yield plus growth makes the most sense when yield is currently close to its long-term mean, otherwise you can adjust for yield changes using the formula I gave in my earlier comment.

        Have a look at Shiller’s S&P 500 data if you want to dig into the empirical details of that market’s long-term dividend growth and yield record (the FTSE 100 is similar, but nobody seems to have such a century long data set for the UK):

        http://www.econ.yale.edu/~shiller/data.htm

  7. It’s easy to critique his investments after the event. But when I did look in detail (whilst it was imploding) at what he was buying horror mounted. For example, he invested in a cold fusion company based on technology that has more than a whiff of fraud. How the hell did that get pass his investment filters?

    Then when I looked at the valuation attached, I became very wary, it could easy be worth nothing, yet the valuation was sky high. He at least published what he held, many funds are considerably more opaque.

    1. Hi Martyn, I’m also wary of criticising Woodford’s stock picking (other than the crazy idea of holding illiquid investments in a liquid fund) because we never got to see his long-term results. However, at a minimum I would agree with you that the companies he was investing in (both liquid and illiquid) didn’t seem to match up with people’s expectations given his long track record of investing in blue chip dividend stocks.

      As for his transparency, I think it was a brave attempt to try something different in the interests of his investors, but in the end all it did was give short sellers a list of stocks to short.

  8. Hi John,

    Quick question because you’ve been doing this for a lot longer. I was looking at growth stocks and I’ve noticed that if you follow yield its rarely a bargain within the normal context when share price corrects. However if you look at EPS it often shows that the stock is clearly bargained.

    Now you probably have guessed I have preference for quality stocks and I am leaning to the conclusion that EPS is a better marker of the stock being undervalued because often a good quality company retains its earning because it can achieve a better return for its shareholder compare to just returning it like VISA What does your research say?

    Thanks

    Reg

    1. Hi Reg

      In theory dividend yield is kind of irrelevant if management are retaining earnings only if they can generate above market rates of return.

      So if a company generates returns on capital of 20% then in theory you don’t care what the dividend is, as long as the company only retains earnings above a hurdle rate of say 10% (or 12% or whatever your hurdle is).

      Any earnings that cannot be retained at above market rates are returned as a dividend for the investor to do with as they wish.

      So from that point of view it makes sense to focus on PE over yield, especially if you’re investing in high ROCE quality companies.

      But, I do look at yield because a) I think the future is an uncertain place and I want some concrete return on my investment now, just in case the company goes rapidly downhill at some point, b) I eventually want to be financially independent using only the natural yield from my investments as that doesn’t involve selling down capital, which means the investments will outlive me.

      So in theory PE is the better measure if ROCE is consistently high (and ignoring all other factors like market prospects etc), but dividends can be useful as a hedge against uncertainty and, obviously, as a form of cash income.

      1. Hi John,

        Thanks for the input always appreciate it.

        I was thinking that high quality companies rarely become available at prices which a typical value investor would lean to. However in the long run they outrun the market. Part of the reason is that they hold onto the income generated and reinvest it back into the business which are able to generate far better returns than the market itself. Unfortunately this means only a small portion of the income is paid out and on paper this translates into a dividend yield of 1% to 2.5% on average. On its own it’s fairly lousy but not if you think of it in the bigger context.

        A year ago I would baulk at the prospect of paying for such low paying dividend stock. However looking at how companies of this nature have performed historically to me it seems that paying a richer valuation (within reason) is worth considering.

        I would still demand a margin of safety and I was thinking that P/E is probably a more appropriate metic to determine if the company is available at a fair price. Although I probably would expect very low debt given the premium price I am paying for the share.

        The last thing I would say is that I would expect these companies to have a low market cap relative to the mega cap companies. That way I know the company has ample of opportunity to grow. For example Hershey was only worth around $156 million in 1979 but at the same time Exxon Mobile was worth $15 billion dollar. Between this time frame Exxon Mobile stock has risen 20 times but Hershey jumped by 140 times. The most obvious reason is that for a mega large company such as Exxon Mobile it can only keep pace with the global economy because friction comes into play.

      2. Hi Reg, I pretty much agree with all of that and to some extent it’s how I try to invest, except I’m a bit more flexible on the price/value/growth/roce combination.

        For example, I own Burberry which now has a sub-2% yield, so it’s not exactly cheap. I’d rather the price was lower but I’m not looking to sell yet, as long as the return on capital and growth rate hold up.

Comments are closed.

%d bloggers like this: