Top fund manager Neil Woodford has dumped Rolls-Royce (LSE: RR). It’s a big deal. He’d held shares in the aerospace giant for the best part of a decade. Furthermore, the company not only featured in his mainstream equity income fund, but also was one of just four of “our highest conviction blue-chip ideas” when he launched his smaller-company-focused Patient Capital Trust in April this year.
Through the summer, Woodford had actually been adding to his stake in Rolls-Royce, and, as recently as 22 October, one of his team was blogging bullishly on the long-term prospects of the currently-troubled company:
“It remains a quality business with superb technology, operating in an industry with very high barriers to entry. It has a substantial long-term forward order book which is the product of a well-executed long-term strategy, years of meticulous product development and a proven business model … we remain confident that the business can deliver to the long-term order book successfully and profitably”.
So, Woodford has done a major U-turn. The straw that broke the camel’s back was Rolls-Royce’s fifth profit warning in two years, released on 12 November. Woodford explains:
“The problems, which initially had affected the military aerospace and marine businesses, now appear to have spread to the core civil aerospace business. This has resulted in material downgrades to profit and cash expectations, and to such an extent that it is now likely that the dividend will be cut in 2016. This has shaken my confidence in the investment case and so the position has been sold across all mandates”.
With City analysts now forecasting a 20% drop in earnings for 2015, followed by a further plunge in excess of 40% for 2016, Rolls-Royce trades on a forward P/E of around 20 — well above the FTSE 100 long-term average of 14.
But it’s the medium-term outlook that concerns Woodford. He explains:
“Rolls-Royce civil aerospace engine business is pretty opaque and difficult to analyse … sensitive to assumptions around manufacturing and servicing costs and operational metrics such as the number of hours flown, reliability and operational longevity. Our decision to sell the shares reflects a significantly increased level of uncertainty about how these metrics will play out over the next 3 to 5 years in a way which will benefit Rolls’ shareholders”.
Of course, investors must decide for themselves how much weight to give to Woodford’s view of the company. And, in fact, not all his comments are negative. For one thing, he acknowledges his caution could be misplaced, and, for another, he rates Rolls’ leadership team highly. Also, he says part of the reason for selling was due to seeing better opportunities elsewhere.
Those better opportunities include healthcare firm BTG (LSE: BTG) and construction materials group Breedon Aggregates (LSE: BREE), both of which Woodford pumped more cash into during November on the back of positive updates.
BTG — which is reinvesting cash flows from its Specialty Pharmaceuticals and Licensing businesses in activities that support its goal of becoming a world leader in Interventional Medicine — has been described by Woodford’s team as “a compelling long-term growth story”.
Meanwhile, Breedon has “a strong management team with an excellent track record of creating shareholder value through organic growth and by consolidating the UK’s fragmented aggregates industry”. Indeed, Breedon has recently announced an acquisition that will transform it into the UK’s largest independent building materials group.
BTG and Breedon are both growing earnings fast, and appear to offer good value to me on forward price to earnings growth (PEG) ratios of 0.8 and 1.0, respectively.