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Carthew: Woodford has too many eggs in too few baskets

Carthew: Woodford has too many eggs in too few baskets

I thought I would start this week by returning to BioPharma Credit, which I wrote about a month ago. If you remember, the big question was: when would the fund get its initial issue proceeds invested?

The fund just took a big step towards this by committing at least $222 million (£166 million) and, possibly, an additional $148 million to a new investment.

This is great news but it turned out to be a loan to just one company, a Nasdaq listed company called Tesaro.

The loan is secured against the revenue of just two drugs (Zejula, which is a Parp inhibitor used to tackle ovarian cancer – it interferes with DNA replication of cancer cells – and Varubi, an anti-emetic used for chemotherapy patients).

This seems like a very significant stock specific risk to me; potentially it could account for 49% of the fund. It is true that BioPharma Credit hopes to expand once the initial issue proceeds have been invested. This would help dilute this exposure. However, in the meantime, the deal may have created some nervousness amongst investors as the premium has halved to about 6%.

Of course, the team at Pharmakon Advisers, which manages the fund, will have done its homework on the drugs. They are confident that Tesaro can expand as it finds new uses for its existing therapies and develops new treatments, supported by the finance that BioPharma Credit is putting in place.

However, the world of biotechnology is fraught with danger as trials that once looked promising come to naught and established drugs are supplanted by new therapies.

Add in the associated political risks, especially given the Republican party’s inept attempts to reform the US healthcare system, and it is obvious why you need a skilled manager to help you pick your way through the minefield.

In a world of quite binary outcomes, diversification seems like a good idea to me. Neil Woodford has come in for intense criticism from some quarters for the recent performance of Woodford Patient Capital and his stock picking skills have been called into question, particularly with respect to the fund’s biotech exposure.

I think that his biggest problem may have been in allowing some of these holdings to become excessively large within the fund. Prothena, one of the latest stocks in the portfolio to experience a sharp drop in its share price, was 15.6% of the fund at the end of October. That’s for a company that expects to burn through about $150 million of cash in 2017.

I cannot help but think that the position size is excessive for a stock as risky as this. Listed funds focused purely on biotech stocks do have large positions but these tend to be in large, profitable companies like Biogen and Celgene. Such a big bet on an unprofitable company with an unlicensed drug seems excessive.

At the other end of the scale, one trust that has been criticised in some quarters in the past for having too many holdings is Herald Investment trust. Its primary focus is on small cap technology stocks (it is the only way of accessing these in the investment companies sector).

The nature of its universe means that it exhibits similar risk characteristics to the funds exposed to the biotech sector, in my view. Herald’s manager, Katie Potts, has long experience of the sector and knows well that even established businesses can come a cropper. This is why she limits the position sizes in the trust, particularly for stocks with unproven technology.

Imagination Technologies, which was recently taken over by a private equity fund, is a great example of why it makes sense to be cautious. It was knocked sideways in April 2017 when Apple abruptly removed its processors from future versions of the iPhone. The shares collapsed from around 270p to near 100p.

Imagination Technologies was one of Herald’s largest holdings but, crucially, Potts had been top-slicing the holding on a regular basis as it soared in value over the years.

Over the time that she held it, even with that share price fall, it made £33 million for the fund. In fact, Imagination Technologies was one of the most profitable (in absolute money terms) investments that the fund has had over the years.

When the proverbial hit the fan, Herald took a hit, but as the position size was not excessive, the damage was not that great. So many other stocks in the portfolio were doing well at the time that Herald’s net asset value actually rose during April. There is merit in diversification. 

James Carthew is a director of Marten & Co and head of investment trust research at the company

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