Should I Pile Into Neil Woodford Picks Rolls-Royce Holdings plc, Next plc And Royal Mail plc?

Well-known outperforming fund manager Neil Woodford reckons he built his portfolio on the expectation that it will receive little help from macroeconomic trends.

If the firms he’s holding deliver decent investor total returns, it will be because they stand on their own merits and achieve advances by hard-earned business growth, operational efficiency, and effective execution of their strategies.

Today, I’m looking at three firms featured in the top twenty largest holdings of the CF Woodford Equity Income Fund: Rolls-Royce Holdings (LSE: RR), Next (LSE: NXT) and Royal Mail (LSE: RMG).

Pushing for a resilient and sustainable business

Aircraft engine manufacturer Rolls-Royce Holdings is in the middle of what the chief executive calls a significant transition from mature engines to newer, more fuel efficient ones, such as the Trent XWB, Trent 7000 and Trent 1000. On top of that, the firm is seeing weakness in offshore marine markets.

That’s all caused a profit headwind in the near term. At 692p, the shares are down more than 45% from the high they reached at the beginning of 2014. City analysts following the firm expect earnings to decline 17% this year and a further 18% during 2016. Yet Neil Woodford is holding on.

At this level, the forward dividend yield is attractive at almost 3.3%, and those reduced forward earnings should cover the payout nearly twice, which makes the dividend look unthreatened. The forward price-to-earnings (P/E) ratio sits at about 16.

I doubt whether Rolls-Royce’s business is in terminal decline. The chief has it that the firm continues to invest in product launches, supply chain transformation, and sustainable business improvements to strengthen the company’s competitive position. He says the firm is engaged in an ongoing operational review to concentrate on how to drive improvements and sharpen focus to make Rolls-Royce a more resilient and sustainable business. To be holding now, Neil Woodford must believe that these actions will pay off down the road. 

Growth and cyclicality

Fashion retailer Next’s shares shot up by more than 750% since their post credit-crunch low in 2008. That strikes me as more than just a cyclical recovery — next is growing, too, and it’s been a great ride for investors, such as Neil Woodford, who kept the faith and held on.

At today’s 7555p share price, the firm trades on a forward P/E ratio of just over 16 for the 2016 trading year. For that price, new shareholders will get a 5.5% forward dividend yield covered just over once by forward earnings, which City analysts expect will grow 6% that year. To me, that makes Next’s valuation tricky. It’s not cheap for a cyclical company trading through, arguably, a mature stage of the general macro-economic cycle.

That said, Next is good at rewarding its shareholders with special dividends and share buybacks, which all serve to enhance income returns — perhaps one of the great attractions of Next as an investment. There is a fledgling international business that could grow, and perhaps there’s much further to travel in the current macro-cycle, which could mean Next achieves steady earning-per-share gains from here for some time to come. However, I’m cautious on Next now.

A low margin, high-competition outfit

Although Royal Mail’s forward dividend yield looks attractive at 4.9%, I’m unlikely to flirt with that payout because I don’t like the firm’s business model. Parcel post is a highly competitive and low-margin business, and letter post is in decline. There’s big potential for a slip in eanings to derail the share price and take back income gains from shareholders.

The shares have been volatile since the firm’s flotation on the stock market at the end of 2013, and volatility seems set to remain a feature of the shares. Neil Woodford is holding and I’m avoiding — after doing your own research, take your pick!

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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.