Kepler Trust report: Woodford Patient Capital Trust

by Thomas McMahon from Kepler Trust Intelligence |

There are few reasons to believe the currently very wide discount might narrow any time soon. 

This content is provided by Kepler Trust Intelligence, an investment trust focused website for private and professional investors. Kepler Trust Intelligence is a third-party supplier and not part of interactive investor. It is provided for information only and does not constitute a personal recommendation.

Material produced by Kepler Trust Intelligence should be considered a marketing communication, and is not independent research.

Thomas McMahon is senior analyst at Kepler Trust Intelligence.

Summary

Woodford Patient Capital (LSE:WPCT) has a concentrated portfolio of early-stage unquoted and quoted companies, focused on technology and healthcare, with high return potential and high levels of stock-specific risk. It is managed by Neil Woodford, one of the most high-profile fund managers in the country. The trust does not pay a dividend.

Neil focuses on picking businesses that he believes have the chance to be successful through the use of new technologies and in whose management teams he has faith. The trust is a pure stock-picking play, with the manager paying no heed to sector or geographic concentration. The drivers of the companies should be secular developments in their fields, and fundamentally global in scope.

The portfolio has become highly concentrated, although position weightings are no longer being published since the open-ended Woodford Equity Income fund has been gated. Most of the portfolio is now in unquoted companies.

Since launch in 2015, the NAV total return performance has been disappointing, with the trust losing 20%, while the FTSE All Share has returned 22.5% over the same period. Since June 2019, WPCT has been affected by the issues in the wider Woodford Investment Management (WIM) business that have led it to fall onto a discount of 45%. One of the fears is that the manager may have to sell unquoted stocks in the open-ended fund which are also held in WPCT, and if he is seen as a forced seller or if this is a disadvantageous time in the development of the companies, this could lead to mark downs to the trust’s NAV.

We note that one potentially attractive feature for investors is that WPCT has no annual management fee. Although there is a performance fee, it won’t be payable until the NAV reaches 146p – an almost 50% uplift to its current level. This means that investors will only pay the 0.18% ongoing charges until that mark has been passed. The possibility of a change of manager has been discussed by the board, and so it is worth noting that these advantageous fee arrangements might not be retained should a new manager be appointed.

Portfolio

WPCT owns a portfolio of early-stage businesses, with a mixture of quoted and unquoted positions. The goal of the trust is to take advantage of the outsized returns that can be made from investing in early stage companies and following them through listing to a more mature stage. The ambitious aim is to generate a greater than 10% NAV return per annum, and although returns have been disappointing so far, the manager, Neil, believes some companies he owns have the potential to grow to be larger than the entire portfolio.

He focuses on picking businesses that he believes have the chance to be successful through the use of new technologies and in whose management teams he has faith. The largest area of concentration is in pharmaceuticals and healthcare technology, as this is where he sees the greatest number of attractive ideas and innovations in the UK and globally, with demand well-supported by demographic trends. However, the trust is a pure stock-picking play, with the manager paying no heed of sector or geographic concentration. The drivers of the companies should be secular developments in their fields, and fundamentally global in scope.

Since the Woodford Equity Income fund was shuttered, WIM has limited the information it provides about its portfolios, so up-to-date numbers of holdings and percentages of NAV held are not available. However, the portfolio has become highly concentrated in a handful of stocks as time has gone on.

The last time it was disclosed (31 May), the top three holdings accounted for 24.3% of NAV and the top ten 54%. With share price declines in the major quoted holdings such as Purplebricks (LSE:PURP), Prothena (NASDAQ:PRTA) and latterly Autolus Therapeutics (NASDAQ:AUTL), the top ten holdings are now mainly unquoted companies, with the portfolio as a whole becoming more exposed to unquoteds.

The major concern for investors at the moment is the effect of the suspension of the open-ended funds on the portfolio. Neil took positions in many of the unquoteds in his open-ended funds too.

As the outflows mounted from those funds, the positions became more and more significant. Now in order to reopen the fund, Neil has stated that he will shift the portfolio towards being concentrated in liquid FTSE 350 stocks, which implies selling out of the positions in the unquoteds – many of which are also held by WPCT.

If Neil is seen as a forced seller, or if valuations of the holdings for sale are not favourable, this could lead to mark downs to the trust’s NAV. Another issue results from the earlier decision this year for the open-ended funds to buy 8% of the share capital of WPCT.

It seems possible these will have to be sold by the open-ended fund, although given WPCT is in the FTSE 250, arguably it would qualify under the new “mandate”. A sale might become more likely if the management of one or the other portfolios changes.

Given the stock-picking approach and the concentrated nature of the portfolio, it is essential to understand the status of the largest positions in the trust to get an idea of its prospects.

It is fair to say that progress on some of the current top holdings has been slower than anticipated. Benevolent AI (8.93% as of the end of May) is still seeking a route to maturation as a business.

The company uses AI technology to research new drugs, aiming to identify connections not previously made in disparate research projects. It has purchased its own laboratories in a substantial change to the business model in an attempt to find a way to profitability. Press reports suggest the company needs new money at a lower valuation than the last Woodford IM investment, in 2018.

Proton Partners (7.83%) has been moving ahead with a series of cancer treatment centres in the UK. Its Wales centre has also been approved by the NHS for its patients. However, we understand the NHS is opening its own centres elsewhere, which surely means the business case for it continuing to use Proton Partners is harder to make. Furthermore, the road to profitability, as explained to us by the Woodford team, involves the NHS increasing the number of cancer patients it treats with proton beam therapy. But this is a clinical issue, and we understand that there are doubts over whether the therapy is appropriate for a wider range of patients.

Oxford Nanopore (7.54%) is, in our view, the most promising-looking stock at the moment. The company’s gene sequence reading technology has received a significant validation from the decision of its larger rival Illumina to pursue similar ‘long-read’ technology, reversing its previous opinion that short-read was the best solution. The company has also received a major investment from US biotech giant Amgen (NASDAQ:AMGN).

Atom Bank (7.31%) has also developed well, although Woodford IM’s holding was diluted when the trust did not participate in some 2018 funding rounds – although it did participate in the latest round in July 2019. Nevertheless, the bank has recently announced it has achieved a positive net interest margin for the first time. It is working towards an IPO in 2021 or 2022.

Industrial Heat (>12% in three lines of stock) is problematic in our view. The company researches cold fusion, considered impossible by most scientists due to the huge amounts of energy believed necessary to generate the fusion of atoms that it depends on.

The sun generates energy through fusion reactions, but at a temperature of 27 million degrees Fahrenheit. It used to own technology generated by a controversial Italian named Andrea, Rossi who has a history of making questionable claims about mysterious technology.

Following a legal dispute, Rossi and IH parted ways, and the company now owns a ‘portfolio of technologies’, which we believe focus on cold fusion, but it does not make this clear. There has to be a serious risk that there is little value in this company, given the history of the technology and lack of disclosure.

Autolus Therapeutics (NASDAQ:AUTL) (6.87%) researches cancer therapies that use the body’s own immune cells to fight the disease. It has suffered delays to its projects and increasing pressure for a breakthrough, with drugs currently in phase one or phase two clinical trials. Unfortunately, despite the promising story, it seems that the problems in the wider Woodford IM business may be a significant factor behind its shares falling 70% year to date. On the other hand, if the progress with its drugs continues, this could provide good performance in future for WPCT shareholders, once the WIM situation is resolved – if the trust can hang on to its shares.

Immunocore (2.68%), Kymab (1.97%) and Mission Therapeutics (1.95%) are other unquoted top ten holdings all engaged in pharmaceutical drug research, with substantial progress needing to be made to bring their drugs to market. Kymab has been planning a listing, which could lift WPCT depending on the valuation achieved.

Gearing

The company has an overdraft of £150 million, which is fully drawn down and on which it pays LIBOR plus 135bps. This amounts to just under 21% of NAV at current levels. The overdraft expires in January, and so one risk to shareholders is that it is not extended and WPCT has to sell assets to pay it back. The company can take out up to 20% of NAV in borrowings at the time of investment.

When he began to use the facility in March 2016, Neil did not view it as structural debt. Nonetheless, there is little prospect of the debt being paid down absent disposals. With Neil having to refashion the open-ended Woodford Equity Income fund to cope with outflows and make the portfolio more liquid, there is the danger that any disposals would be at disadvantageous levels. Clearly the significant gearing adds to the risks of investing in the trust as well as the potential rewards.

Performance

This trust is all about stock-picking and there have been a handful of companies with poor results that have hurt returns. The concentrated nature of the portfolio compounds the damage to investors just as it would magnify gains. In the quoted portfolio, Purplebricks has been a big detractor in recent years, although it rose sharply in 2017 and Woodford has held the stock since before it listed.

One of the most difficult periods for the trust was after a US short-seller targeted quoted holding Prothena in November 2017. At the time, it was the largest holding in the trust, and WIM the largest shareholder in the company. When the company’s amyloidosis drug failed phase three trials in April 2018, the trust took a big hit.

In the unquoteds, Autolus (NASDAQ:AUTL) was a successful float in June 2018, with the trust booking a gain. However, it has declined by over half since flotation. Earlier problems within unquoted biotechs came from Circassia (LSE:CIR), which saw its cat allergy drug fail phase three trials, and Northwest Biopharmaceutics, another target of short sellers and allegations of skulduggery.

It is also fair to say that some of the largest positions in the trust now are companies of which more was expected sooner. Benevolent AI, Proton Partners and Oxford Nanopore, three of the four largest positions, have all had protracted journeys to realising key milestones and profitability. In our view, Oxford Nanopore seems the most likely to reward investors’ patience given developments this year (discussed in the portfolio section).

Industrial Heat, which we believe to be the largest position once three share classes are summed, has had its valuation written up by 357% in 2018, boosting WPCT’s NAV. However, the revaluation was based on a funding round from investors, and not success in its science – although the investors may have based their decisions on their understanding of the scientific developments. Industrial Heat is a secretive company, and it is hard for third parties to properly assess its inner workings and prospects. [Shortly after completion of this report, it was announced that Industrial Heat’s valuation had been written down, hitting WPCT’s NAV by a further 3.4p. By our calculation, this amounts to a roughly 40% write-down to the position.]

Over the past year the NAV has declined, with falls in Autolus and Purplebricks having a material impact. In June, the valuation of Immunocore was written down by around 50%. The unquoted portfolio is inherently more stable in terms of NAV, but given the situation in the wider WIM business there is the danger that there could be write-downs if Woodford is a forced seller (see portfolio section for greater discussion). Certainly, it is these fears that have driven the share price to fall so precipitously as illustrated in the graph below.

Dividend

According to the most recent report and accounts, the board will not be paying a dividend this year. The aim of the trust is to grow capital and there is no mandate to generate a dividend. There was a 0.16p payout in 2015, paid out due to regulatory rules requiring 85% of an investment trust’s income to be paid out to shareholders. This was from a number of mature businesses that were held in the portfolio before it was fully invested in early-stage businesses.

Management

Neil is one of the most high-profile fund managers in the UK, having generated an impressive track record over 25 years managing the Invesco Perpetual Income and High Income funds. His success was built on making contrarian calls on the stock market, most notably by staying out of the 2000 dotcom bubble and avoiding banks prior to the 2008 crisis. Investments in the tobacco and pharmaceutical sectors made when they were out of favour were also particularly successful.

His track record since opening his own firm in 2014 is much poorer, however. The Woodford Equity Income fund is down 12.9% since launch. This is worse than all IA equity income funds over the period and all but one in the UK All Companies sector, where the fund now sits thanks to not meeting the yield requirement of the equity income sector. Woodford Equity Income is now shuttered after outflows made liquidity management impossible.

Woodford Patient Capital is a very different product from the income-focused funds Neil has usually run. However, Neil’s involvement in early-stage companies dates back to the early 2000s when he invested in IP commercialisation companies, some of which form part of the network of contacts he currently uses to generate ideas. After investing in these ‘incubator’ stocks he then branched out into investing directly into the portfolio companies as they sought further funding, and these two types of investment together made up almost 10% of his Income and High Income funds when he left Invesco in 2014. This means that he has had many years’ experience of following early-stage companies through from gestation to listing and beyond.

WPCT leans heavily on the strength of Neil’s network of contacts in the IP commercialisation industry, and the Woodford team is in constant contact with IP commercialisation companies and other private owners looking for co-investors. This means that their ideas come with a level of diligence already done, although the task then for the team is to verify and further that research.

Prior to the shuttering of the open-ended fund, Neil told us that most of his team’s time was spent on WPCT given the nature of these companies demands greater research – and increasing crossover with the equity income portfolios. Clearly, the first priority of the team must now be on the open-ended fund. But on the other hand, the outflows have left some cross-holdings with WPCT as significant positions within Woodford Equity Income.

On 29 July the board announced that the manager had sold 60% of his holding in WPCT between 3 and 8 July to meet a personal tax liability and in lieu of an income from the management company, which he is not taking while the Woodford Equity Income fund is closed. He retains 0.14% of the shares in WPCT.

Discount

The discount has widened out to 45% following the shuttering of the open-ended Woodford Equity Income fund, which raised the possibility that the manager will have to sell some of the shared holdings in WPCT and the open-ended funds. With the possibility that stakes would have to be sold below carrying value, this would mean write-downs to the NAV of the trust.

Additionally, the open-ended fund holds 8% of WPCT shares which, again, if the fund is a forced seller this could further negatively affect the share price.

Charges

The trust has no management fee, with the OCF of 0.23% covering only the administrative costs. Woodford IM will only be paid a performance fee once the trust has achieved its hurdle rate of 10 per cent returns per annum. This hurdle rate is cumulative, so for the manager to be paid a fee would require the NAV to rise from its current 79p to 146p in the current financial year. The manager will be owed 15% of the NAV returns above the hurdle rate, subject to a high watermark.

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