Saturday, September 09, 2017

The fallacy of value investing - with Neil Woodford

This week, star London-based fund manager Neil Woodford talked about his recent poor performance, mainly as a result of the huge losses suffered in his holding in Provident Financial.

Below is the chart, which tells its own sorry story:

In the articles I have read, Woodford appeared to be lamenting the 'hysteria' and 'irrational behaviour' of traders and investors in the market. The price gaps in June and August were as a result of profit warnings being announced - the second of which led to a reported loss suffered in excess of £300m across his funds.

Maybe the hysteria he is talking about was actually other traders and investors reacting to seeing those profit warnings, and they simply cut their losses and moved on. 

When I come across situations like this, I am reminded of a story Ed Seykota once told:

"One evening, while having dinner with a fundamentalist, I accidentally knocked a sharp knife off the edge of the table. He watched the knife twirl through the air, as it came to rest with the pointed end sticking into his shoe. 'Why didn't you move your foot?' I exclaimed. 'I was waiting for it to come back up' he replied."

Of course, the danger in looking for 'value' is that what appears to be cheap, can end up being a lot cheaper (and consequently better value) a few weeks or months later if a downtrend takes hold.

"I believe Provident Financial shares started the day undervalued, and have become even more so as a result of the market’s reaction to today’s news." - Neil Woodford, 22 August 2017

The trend is clearly down. Where is the bottom? Can it go lower?

It was interesting to note that, in the aftermath of the latest profit warning, he started talking about price earnings ratios, dividend yields etc., in an attempt to put some positive spin on the situation. Sure, like the 'assumed resumption of the payment of a dividend' he talked about would be a justifiable reason for holding onto a £300m+ loss...

"I don't believe that there is a problem with owning a large stake in a business that is profoundly undervalued."

"It's a great portfolio, one that I own and want to own more of. The short-term performance is painful and is difficult, but it isn't a permanent loss of capital." - Neil Woodford, 07 September 2017

I have long talked about the merits of long-term investors including a trend following element in their selection process. Even a simple metric such as the 200 day moving average would help. Tellingly, price had been oscillating above and below the 200 day moving average for over a year, and dipped below it again just ahead of the first profit warning back in June. Of course, it is way below that now:

A couple of years ago, I had the pleasure of meeting a portfolio manager who works at a major investment bank in the City of London. Although their portfolio recommendations are fundamental based (and determined by committee), plus they are restricted in their selection process to the constituents of the FTSE 350, it was noticeable when he said that they experienced an upturn in performance when they added a trend filter to help with the timing of their buying and selling activity.

Of course, this was not a surprise to my friend, who had an encyclopedic knowledge of trend following and its merits. It was the first time someone starting quoting Dickson Watts' Speculation as a Fine Art to me!

I am not setting out to diss Woodford here. He has a long and successful track record in what he does. And obviously to achieve what he has, there has been some stocks held for a very long time to generate the big returns required to offset the occasional big losses such as this. 

And I accept and understand that when you run such a fund, and hold such concentrated positions in a stock, it would be impossible to sell out in one go (Woodford's funds owned a significant chunk of the Provident stock - a bit similar to the approach of  Bill Ackman and his holding in Valeant Pharmaceuticals).

But his approach couldn't be further from my own, or of those who consider price and its movements to be their primary concern.

I am least hopeful that individual traders who read this post will appreciate the potential devastation a holding like this can cause in your own investment portfolio or trading account, not to mention the emotional upheaval. 

It's the age old principle again of cutting your losses at the first sign of trouble. Taking a small loss is frustrating, but it sure beats taking the mother of all losses...

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