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Six Lessons For P2P Lenders From Neil Woodford
Cliff is an experienced freelance investment journalist, who is 4thWay's guest “P2P Cynic” and P2P investment fund writer. Read about Cliff.
Five years ago, acclaimed fund manager Neil Woodford was sitting on top of the world.
After 26 years of unparalleled success at Invesco Perpetual, where he managed income funds worth £26 billion at their peak, Woodford quit in 2014 to start his own firm, Woodford Investment Management (WIM).
Woodford's star falls to earth
Unfortunately, just as meteors plunge to earth, so too do many former financial stars. Earlier this month, following a flood of hefty withdrawals from his main fund, the Woodford Equity Income Fund (WEI), Woodford was forced close the gates to WEI, by suspending all movements of money in and out with effect from 4th June.
The main reason for this decision was to prevent a “fire sale” of the fund's remaining share holdings. Considering the large size of the fund and its substantial holdings, a rapid sell-off like that could only be achieved by selling the shares at deeply discounted prices – and at a steep loss to investors.
However, the underlying issue was that WEI had performed poorly in recent years by repeatedly losing money by backing unsuccessful companies.
For example, in the year to 31st May 2019, Woodford is ranked 111/111 amongst UK Equity Income managers, losing his investors almost a fifth (19.1%) of their money in just 12 months. And over five years investors have made no money, whereas simple investment funds blindly tracking the stock market are up 30%.
What went wrong for Woodford?
Critics have been queuing up to take personal potshots at Woodford in the press, but I will refrain from doing so. (What's more, I should declare a former interest: prompted by me, my wife invested in his Invesco Perpetual High Income fund in the mid-Nineties and its superior returns over her many years of ownership made it the #1 fund in its sector. Result!)
Then again, Woodford – perhaps in a fit of hubris caused by believing the hype – made some catastrophic mistakes that steadily snowballed into the situation he is in today. These are the slip-ups Woodford made that slowly but surely strangled his success, together with the lessons all investors, including those doing P2P lending, can learn from his blunders:
Mistake #1: “Mission creep”
A military term, mission creep (sometimes referred to as mission shift) is the gradual transformation of a project well beyond its original intentions, often driven by initial success. After Woodford went it alone in 2014, he launched four broadly similar income-focused funds, all of which entered the UK Equity Income fund sector. So far, so good.
Bizarrely, and across all four funds, only a minority of Woodford's investments were traditional income-generating shares in companies that pay high and rising yearly cash dividends to their shareholders. In other words, Woodford was moving away from his original expertise, which was to make money from cheap shares that paid handsome incomes to their holders over time.
Lesson #1: Stick with what you know
When it comes to investing, including P2P lending, it pays to “stick to your knitting”. As billionaire investor Warren Buffet repeatedly remarks, “invest in what you know” and “never invest in anything you don't understand.”
Mistake #2: Transparency
Woodford's second slip-up was to create a lack of transparency for investors. Naming all four WEI accounts ‘income funds' when they owned shares in few income-generating companies was somewhat misleading, in that he was being less than clear, open and honest with his followers.
Lesson #2: Does it do what it says on the tin?
Ronseal wood-stain became hugely popular because its advertising slogan was delightfully simple: “Does exactly what it says on the tin.” Before, for example, investing in a particular P2P account or loan, read the small print very carefully and if it differs from what you want, need or expect, then walk away. Otherwise, you might end up buying the wrong kind of tin.
Mistake #3: Small isn't always beautiful
Woodford's quarter-century of success was the result of a deceptively easy strategy: buying shares in large, dividend-paying companies and holding them for decades. Alas, in an effort to juice the returns from his WIM funds, Woodford bought stakes in smaller and smaller companies.
Over the very long term, small-company shares tend to outperform blue-chip shares – largely because they are riskier and more volatile. However, many small companies underperform or even fail, which is partly why there are so few mega-companies in each industry.
Lesson #3: Higher returns come at higher risk
An old Russian proverb warns, “He who takes no risk drinks no champagne”. Unfortunately, as some investors learn, he who goes broke also drinks no champagne! In other words, when investing in P2P loans, accounts and platforms, don't be lured into choosing the highest rates/returns. Otherwise, your portfolio will be skewed too heavily towards risky lending and, when the economy weakens, you could come a cropper.
Mistakes #4-6: Falling into the liquidity trap
Above all his other mistakes, Woodford's crushing humiliation was caused by an age-old problem: a lack of liquidity. Liquidity describes how easy (or hard) it is to sell assets in volume at or close to market prices. For example, selling a house takes a lot of time, effort and money, whereas selling lots of shares in a FTSE 100 firm can take a single mouse-click.
Regrettably, when it came to liquidity, Woodford made three toxic mistakes:
- First, he invested heavily in smaller companies, whose shares are generally trickier to sell.
- Second, he bought stakes in unlisted and private companies, whose shares are not quoted on recognised stock exchanges. These holdings are downright difficult to sell without an eager buyer willing to take them off your hands.
- Third, he compounded his liquidity problems by buying commanding stakes in several companies. Indeed, it was not uncommon for WEI to own more than a quarter (25%) of all the shares of some businesses. Those are big stakes to try and sell in a hurry.
Lessons #4-6: Learn to diversify, Diversify and DIVERSIFY
As I mentioned above, investing in less well-known assets can produce bumper returns. However, aggressively buying illiquid assets – such as a few large P2P loans from an obscure P2P lending site – can turn out to be a recipe for ruin.
Luckily, P2P loans usually take place over shorter periods, with P2P lending generally paying back around two-thirds (67%) to all (100%) of your money naturally, through borrower repayments, in just 18 months.
Therefore, when P2P lending in particular, be very wary of tying up more than you can afford to spare in a single loan, account, platform or timeframe. The horizons of P2P lending are shorter and more stable than stock-market investing, but avoid accidentally concentrating your risk. The best way to do this is by diversifying: spreading your eggs across a wide range of baskets.
In summary, as 4thWay founder Neil Faulkner warns P2P investors, “Don't invest if you might need or want most of your money back in a hurry. You can't fight the tide!”
More from Cliff:
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