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CF Woodford Equity Income Fund Update

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August was a brutal month in equity markets, as the plunge in Chinese stock markets continued, spreading panic worldwide.

Early in the month, the Chinese authorities allowed the renminbi to devalue over three consecutive days. This caused concerns about currency wars and the prospect of deflation being exported around the world, and prompted fears that China’s economic situation could be much worse than previously suspected. Then, on 24 August, the domestic Chinese stock market suffered its biggest one-day fall for eight years, compounding its earlier losses and causing an immediate sell-off in global markets. Although most developed indices recovered some of their poise thereafter, all major markets fell in dollar terms over the month.

Although there were some powerful technical factors at play which may have contributed to the extreme volatility, the move lower was initially triggered by a sudden realisation by the equity market that the fundamental health of the Chinese economy and indeed the wider global environment were not as robust as valuations had been implying. That the Chinese economy is slowing has been no secret, however – recent quarterly growth figures have lacked credibility when compared with other real economic data. The problems in China are significant and further vindicate the cautious view of the global economy that we have held for some time.

Given our concerns about productivity, deflation, debt and the overall global growth outlook, we have built the portfolio on the expectation that it will receive little help from macroeconomic trends. In general, this strategy and our overall investment approach served the fund relatively well through the volatile conditions, although the portfolio was unable to avoid a decline in absolute terms.
Among the largest detractors this month were our large-cap tobacco and pharmaceutical holdings: British American Tobacco, Imperial Tobacco, AstraZeneca and GlaxoSmithKline. In a panic-driven sell-off such as that which we saw in August, it’s often the largest and most liquid stocks that get hit hardest first. We have seen no fundamental justification for the share price declines and we added to each of these holdings, and several others, during the market turmoil.

Our US biotech holdings were also hit hard. The month’s largest detractor was Northwest Biotherapeutics, after rumours that the clinical trial of its DCVax-L oncology treatment had been suspended. The company has confirmed that the suspension related simply to the recruitment of new patients and was a temporary measure while regulatory information was submitted, in line with clinical protocols. The trial is continuing and we see nothing untoward in this development. Alkermes and Prothena sold off heavily too – again, we have no fundamental grounds for concern and were able to take advantage of the share price weakness.

The most important positive contribution came from one of our unquoted holdings, Stratified Medical, which was subject to an independent revaluation. Stratified Medical is a technology company serving the global healthcare industry which combines human intuition with powerful algorithms to intelligently search and contextualise existing scientific research. When we first invested in the company in October 2014, the company had already identified and out-licensed two new potential targets for Alzheimer’s disease and had also successfully demonstrated the platform’s ability to identify other new prospective therapies. The funding round was intended to allow further development work on its technology platform to progress it towards ‘self-learning’.

Since then, the Alzheimer’s programmes have progressed extremely well, with the targets being successfully validated and initial milestones met. Furthermore, confidence in the platform’s broader capabilities is increasing, as is interest from the wider health care industry in this extraordinary technology. Consequently, the company has recently announced a further funding round which we participated in and the value of the existing stake has been independently uplifted to the new valuation. We continue to see considerable long-term growth potential in the business as it continues to develop and commercialise its very impressive intellectual property based around a unique partnership of artificial intelligence and healthcare innovation.

Elsewhere, Circassia performed well despite little in the way of news. The company’s share price strength may have resulted from its likely inclusion in the FTSE 250 later this month but investors may also be warming to the potential of its recent acquisitions of Aerocrine and Prosonix, which position Circassia as a world-class allergy and asthma specialist.

Several of our intellectual property commercialising businesses, such as Allied Minds, IP and Imperial Innovations, were also all among the top contributors for the month, with all of them bucking the general downturn in the market to produce modestly positive returns.

Our main portfolio activity in August focused on taking advantage of the indiscriminate share price falls that accompanied the market panic towards the end of the month. This allowed us to add to a number of existing holdings at incredibly attractive valuation levels.

We also introduced two new US health care positions to the portfolio in the form of AbbVie and Theravance Biopharma. AbbVie trades on one of the most attractive valuations in its sector despite also offering one of the fastest anticipated growth rates. This is in part explained by fears about the future of Humira, AbbVie’s treatment for auto-immune conditions such as rheumatoid arthritis, Crohn’s disease and ulcerative colitis. Humira is the biggest selling drug in the world and continues to grow quickly but is due to come off patent soon. The valuation discounts an immediate threat to the franchise once the patent estate starts to expire, but we believe that this significantly underestimates the extent to which AbbVie can protect the Humira franchise through further innovation and overestimates the probability that generic ‘biosimilars’ can be launched. Theravance Biopharma, meanwhile, is an earlier stage biotech business with one on-market drug (a new antibiotic for difficult-to-treat infections) and a very exciting clinical pipeline.

Cequr also joined the portfolio as an unquoted position. This Swiss early-stage business has developed a simple 3-day patch-like insulin delivery device for people with type 2 diabetes. The recently completed funding round provides Cequr with the capital to complete its clinical and regulatory requirements and commence commercialisation of the device.

We also continued to add to the holding in Essentra, the plastics and packaging firm, throughout the month. We know the business (it was spun out of Bunzl in 2005 and we were initially shareholders in both) and its management team well (we knew Colin Day, chief executive, for a long time as finance director of Reckitt Benckiser). Day and his team have achieved a lot in recent years, improving margins, increasing investment and reshaping the business through merger & acquisition activity. The shares have tended to perform well to reflect this transformation but recent under-performance has provided an opportunity to build a position at an attractive valuation level.

In terms of disposals, we reduced the position in Centrica which had held up relatively well in the early part of the market declines. We also reduced the position in Zegona and trimmed Royal Mail following its robust performance in recent months.
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The views expressed in this article are those of the author at the date of publication and not necessarily those of Woodford Investment Management LLP. The contents of this article are not intended as investment advice and will not be updated after publication unless otherwise stated.
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