“Past Performance is not an indicator of future returns” - the warning message on almost every advert for an investment fund, or “Caveat Emptor” as the Romans would have told us.
The warnings we’re always told should stoke appropriate research and caution but the want for a “better than average return” so often drives our greed to take advantage before we’re too late to the party.
And so to Neil Woodford and Woodford Investments and the suspension of withdrawals from his OEIC (Open Ended Investment Company) the Woodford Equity Income Fund and its impact on his listed fund vehicle, the Woodford Patient Capital Trust. A star fund manager known for stellar returns for decades attempting to stop the rot from poor performing investments and the knock on effect of withdrawals forcing him to sell down on his more liquid holdings. I’ve been fascinated with this story, since it came to light a couple of months ago that his fund had begun to get into trouble and that the allocation of non-liquid small cap and unlisted assets was starting to rival his more liquid holdings.
There’s
so many takeaways to be had from this ongoing story:
- Woodford, once viewed as Britain’s answer to Warren Buffett, showing fallibility the Sage of Omaha has never come close to, as his fund is forced to suspend redemptions for fear of being unable to honour those redemptions without closing the fund down completely.
- How the speed and size at which investors were looking to redeem their money from the fund forced him the sell down his larger cap, more liquid holdings reallocating his portfolio to be made of more illiquid or entirely illiquid stocks effectively changing his overall strategy and making it harder to keep up with the increasing number of redemptions, including Kent County Council’s final blow of wishing to pull its entire £263m which led to the suspension.
- How Woodford took sizeable holdings in relatively early stage companies (which couldn’t easily be disposed of) in the estimation that some of these would come good when their ‘unique’ product came to market and he could take advantage by making money from of a main market listing. Did his investors really know what his fund’s aim was about? Do most retail investors ever really pay close attention to what a ‘star name’s’ fund is doing or do they just assume it will make them money?
- Or how he avoided breaking the requirement to only hold a certain number of unlisted stocks by listing some of his private holdings on the almost completely illiquid Guernsey stock exchange and entering into an asset swap with his Patient Capital Fund to buy himself some time. This asset swap which gave the Equity Income Fund shares in the Patient Fund in return for some of those illiquid holdings, indelibly linking the fates of the 2 funds even closer together, as when Woodford would be forced to sell down on his Income Fund assets for the redemptions to investors, the Patient Fund itself would now be 1 of those assets, driving its price even further down.
However the story I want to follow is the ensuing battle now
taking place with those seeking to bring him down further and the knock on impact on the companies he sought to invest in.
A
few days after the suspension of the fund came the news that hedge funds were
targeting his investments (#link to Times article) by short selling all his
holdings based on the list of stocks the Woodford Funds held, which was published
on its own website. In the knowledge that Woodford would be forced to sell
these stocks to get back on track, hedge funds sought to drive the value of
those assets even lower by selling them ‘short’, meaning that when Woodford
tries to sell his significantly sized holdings, especially the more illiquid
stocks, he would only be able to do so at an even more depressed price, putting
his funds (and investors) in an even more perilous place, effectively pushing
him closer to the shutdown he is trying to stave off. But of course this short
selling also had an adverse impact on the stocks he held, many of which did
little more wrong than to be a holding of a fund forced into a fire sale.
Woodford in response has now changed his website to only disclose the top 10
shares in each fund, to prevent any such attack from escalating.
So
how is this possible?
Going
short on a stock, effectively means for an investor (bank, hedge fund or
individual) to sell a share which they don’t own. How can you sell something you don’t own? You borrow it.
Confused?
Imagine an investor might believe a particular stock is significantly overvalued. If he doesn’t own it, in theory he can’t sell it to realise a profit. But the market does let him sell shares into the market at the current value so long as he delivers the shares on time. He is obligated to deliver those shares to the buyer in 2 days time (the date of settlement), or risk defaulting on those obligations and be sued/fined. In order to ‘cover the short’ he can borrow the shares from someone that owns them and use these to settle on the shares he shorted.
In return for borrowing the shares, the investor pays the owner of the shares a fee for every day the borrow is in place. Eventually when the investor feels that the share price has fallen enough (or he needs to close out his position) he will buy back the shares in the market and return them to whoever he borrowed them from. If the price has fallen over that time, then then he makes a profit based on the difference between the price he shorted the shares at and the cost of buying them back, less the cost of borrowing the shares. If the lender of the shares wishes to get his shares back at any point then the borrower of the shares will either have to buy the shares back in the market to return them, or find someone else to borrow them from.
So why would anyone be willing to lend their shares for this purpose? There might be several reasons. For example if you’re a long term shareholder, you might just be sitting on the shares and getting a capital appreciation/depreciation as the share price rises and falls, in addition to any dividends. By lending some of the shares out over a period of time, you still remain the ultimate owner of the shares but benefit from additional funding in the charge you make from lending them. This can act as an additional form of revenue from the shares, although you would want the shares back for the purpose of voting rights or dividends should they be required. Another reason might be a bank which for the purpose of risk management sits long on shares of a given company across its trading books. Similar to how a bank would use cash deposits it receives in to lend out, a bank would want to lend out any stock holdings it’s sitting on to squeeze any additional income it possibly can from the holdings.
The practice of short selling itself dates back almost as long as the earliest stock markets, with records showing an early 17th century investor attempting to assert pressure on the Dutch East India company by shorting its shares and demanding a greater share of its profits. Many Hedge Funds have long made a success from trying to short stocks which they see as having a poor business model and being overvalued. They look to profit from what they believe to be the imminent fall in the price, once the market realises a correction is due, all the while hoping that any initial uptick is short lived. But some hedge funds have attempted to take large short positions in companies to force their share price down whilst simultaneously speaking out about what they perceive to be bad practices or signs of future downturn or demise, which if other market participants take heed, could itself lead to a downturn in the price creating profit for the hedge fund. A potential self-fulfilling prophesy which, unless the rumours are something the shorted company can clearly disprove, can easily gather a downward momentum forcing that company itself into difficulties if it causes investors, creditors or customers to withdraw their support.
There’s
many famous examples of hedge funds exerting such pressure, none more so than
during the 2008 financial crisis. There first Bear Sterns and then Lehman
Brothers saw hedge funds take up short positions in the banks as the mounting
evidence pointed to poor trading decisions and the ever growing bad assets on
the banks books. Short investors such as Steve Eisman of Frontpoint and David
Einhorn of Greenlight Capital were vocal in taking a dim view of Bear and
Lehman respectively and how these banks and the banking industry as a whole was
in dire straits. (Here’s Einhorn speaking for real about Lehman in June 2008on CNBC laying out the issues with Lehman,
or of course more entertainingly you can watch Steve Carrell portraying Mark
Baum, the Big Short’s fictional version of Eisman, in destroying the banking
sector as a whole as set during the crisis while Bear Stern’s stock plummets tothe floor).
In
both these cases the outspoken views proved correct as both banks ultimately
collapsed to zero, but there certainly a case that the shorting of the stocks
by investors such as these assisted in pushing the negative direction of the
share price at a much quicker pace than it otherwise may have done. (Ironically,
Steve Eisman now works for Neuberger Bermann, the Asset Manager once a part of
Lehman Brothers before it was spun off in a management buyout post-bankruptcy.)
Short sellers don’t always get it right or have it their own way.
As with any speculative investment a short seller can get caught out when their
negative view is found out to be false and the stock rises, or even if short
term large rises in the stock mean they can’t afford to suffer the paper losses
in holding out too long for their investment hypothesis to come to fruition.
One case back in October 2008 actually saw Volkswagen temporarily become themost valuable company in the world.
As short sellers took a negative view on Volkswagen, Porsche, who already owned
31% of the company, took out option positions which effectively gave them 75%
of the company. That coupled with Lower Saxony holding a 20% stake of its own
meant there was only 5% of free float shares tradeable in the market. With
12.8% of Volkswagen shares being lent out for short selling, the hedge funds and
other investors who had shorted the shares were forced into a desperate
scramble for the remaining shares on the market to close out their positions.
This sudden demand for the VW shares pushed them sky high, rising 82% at one
point, and led to the short investors being caught out and losing substantial
losses on their positions.
Given the speculative nature in the ability to short shares and
the potential downward pressure it can be used to put on even sound companies,
why is it still allowed? There are several reasons, one of which is that the
ability to short a company provides additional liquidity in a market where it
may otherwise be restricted if you could only buy or sells shares that you
owned. Similarly, the multi-trillion dollar equity derivatives market relies on
the ability to short sell stocks, without which many derivative providers would
be unwilling or legally prevented from making a market. There have been times
when the ability to short sell has been restricted, such as the limited ban on
short selling banking stocks immediately after the Lehman Brothers collapse in
2008, in an effort to prevent a complete run on the global baking system. But
any efforts to put a permanent ban on short selling would likely be more
detrimental than beneficial.
Which brings us back to Woodford, and his fight against the
shorts. Investment decisions in the market has long gone past just buying
companies based on the fundamentals, and plenty of investors, such as some
hedge funds, will use what opportunity there is to prey on those on the way
down. Some of the shorts involving Woodfords Equity Income Fund holdings were placed
against his listed Fund, the Patient Capital Trust, further depressing its value.
Given the Equity Income Fund’s increased holding in the Patient Capital Trust
following the asset swap, it perhaps seems inevitable that in any sell down,
the Trust will be forced to be sold to raise money for reallocation into more
liquid holdings or further redemptions on reopening, thus attracting short
investors. But the Patient Capital Trust and the Equity Income Fund also share some
of the same smaller cap investments, opening them both up to investments short
sellers deem most at risk from Woodford’s reallocation or redemption
requirements.
Will the shorts increase as it becomes more inevitable that
Woodford will have to sell certain assets, thus further reducing the proceeds
he can make available for any reallocation? The fact that he is now only
publishing the top 10 holdings in the portfolio where previously all holdings
were available suggests that Woodford feels this also. Hedge Funds spotting an
attempt to force Woodford into an embarrassing fund closure by seeking to
further depress the value of the stocks he holds before he can sell them. What
better scalp to have than to state a part in bringing down “Britain’s answer to
Buffett”. But perhaps Woodford’s ongoing difficulties and underperformance over
the last few years has instead rather increased focus and questions on some of the
underlying companies. FTAlphaville is not alone in shining a light and raising
questions on some of Woodfords small company investments with its takedown of
BenevolentAI and its questionable current valuation. It’s probably fair to say that a fair
number of the small cap companies sitting in Woodford’s Portfolios are just as
much one announcement away from a valuation collapse as they are from getting
to unicorn status. It’s no wonder short selling investors may have noticed the
same.
Time will tell whether Woodford’s can repeat his past record,
which got him his name as one of Britain’s best stock pickers, and once again
come good with the majority of his picks. But time may not be on his side, as
investors push for the end to suspension so they can at least reclaim some of
their money and vultures sit at the gates waiting to prove him wrong.
