Neil Woodford, regression to the mean, and learning from the past
19 August 2019
To what extent is investment success a factor of randomness and investors’ susceptibility to being fooled by it? Colum Wilde, founder and CEO of CleverAdviser, ponders the question in relation to Neil Woodford’s funds
“The markets can remain irrational longer than you can remain solvent,” proclaimed the great economist John Maynard Keynes. Maybe the markets have been irrationally punishing Neil Woodford for the right decisions.
Or maybe, Neil Woodford made that most catastrophic of errors — he believed the hype. He was adulated by the media and investors, but success can fool the wisest, even the humblest amongst us can be taken in by flattery.
Is it possible, however, that Woodford had been lucky and that his luck finally ran out?
There is another way to describe it: regression to the mean. Compare investing with tossing a coin. If you were to toss a coin 1,000 times, the laws of probability suggest that at some point you will get heads 11 times in a row, and tails 11 times in a row, too.
Let’s say investing is all down to luck. Then, let’s say there are a thousand fund managers, and there is a 50/50 chance they will beat the markets in any one year. This would suggest that one of these fund managers would beat the markets 11 years in a row, even if each of those fund managers applied a stock picking process involving a blindfold, a pin and randomly selecting each stock.
For a 25-year period from 1997, the Woodford-managed Invesco Perpetual High Income Fund beat the markets 17 times. Was that because Woodford was brilliant, or because the forces of randomness smiled upon him?
One advocate of the idea of regression to the mean is Leonard Mlodinov, of the Californian Institute of Technology and author of the ‘Drunkard’s Walk’.
Mlodinov tells the story of Sherry Lansing, a one-time CEO at Paramount Pictures who commissioned Braveheart, Titanic and Forrest Gump. Following a series of box office failures, critics said that she had lost her touch. Indeed, soon after she left, Paramount enjoyed another run of hits, but the movies that did so well were commissioned by Lansing before she left. Was she a victim of regression to the mean? Mlodinov also quotes one Hollywood executive who said: “If I had said yes to all the projects I turned down and no to all the other ones I took, it would probably have turned out just the same.”
The writer Nassim Taleb has a similar idea, he says we get fooled by randomness.
Maybe you have had that experience when playing a sport, squash for example. One day everything goes right, one brilliant shot after another — it is as if you can do no wrong. Alas, you are never able to re-capture that form, maybe you were a victim of regression to the mean.
Perhaps we are being unkind and Neil Woodford does have a certain innate ability. Returning to the coin analogy, if the coin was ever so slightly weighted in favour of heads you will still see occasions when you get tails several times in a row.
The problem, however, with Woodford’s recent investment performance runs deeper. He made his name as a picker of income yielding stocks. Since he went it alone, he has been investing heavily in unquoted stocks, an approach known to be risky.
This is not necessarily a bad thing — there is not enough investing in unquoted stocks in Britain, that is why so many successful techs come from the US, and why the UK, home to many of the greatest tech innovations of all time, lags so far behind in the tech sector.
Investing in unquoted is a core part of The Woodford Patient Capital Trust. It’s an approach that needs time — that’s why it’s called patient capital.
Another level of complexity is added by a characteristic of technology, that consultancy and research company Gartner calls the Hype Cycle. A new technology often gets overhyped at first, then goes through a trough of disillusionment, before finally fulfilling potential.
For investors, this hype cycle is problematic — some stocks can lose value before recovering, some never recover.
Woodford, maybe buoyed by his earlier successes, creating a confidence that may have been oblivious to the effect that randomness had on his earlier successes, included unquoted stocks in his Woodford Equity Income Fund. He may well have considerable ability at picking income stocks, but that did not qualify him to invest in highly specialised and risky healthcare tech companies. Maybe, a confident Woodford, fooled by randomness, was seduced by his past successes, to move away from his area of core competence, and now he has been struck by regression to the mean.
Or maybe the markets have failed to grasp his long-term plan, in which case, can he stay solvent before the markets become rational?
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