Neil Woodford's market-thrashing calculation

Since launching his own CF Woodford Equity Income fund 26 months ago, outperforming fund manager Neil Woodford has seen a 30% return. That's a cracking result that tops an illustrious career so far in investing and that proves that he has lost nothing of the investing prowess that made him famous in the world of investing.

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A simple approach

It would be easy to assume that Neil Woodford's approach to selecting shares might be complex, but in a recent interview he revealed that he starts with a basic calculation for judging a firm's appeal, saying: "In very simple terms, our total return expectation for a stock equals its dividend yield plus the anticipated rate of dividend growth."

He went on to acknowledge that a change in valuation of a company due to the fluctuation of its share price will either enhance or erode this return. However, it's interesting that he puts no reliance on capital gains, considering them a bonus if they happen. As Mr Woodford goes on to say, "...this is a very straightforward way of looking at prospective returns."

I'm sure that he and his team of analysts work hard to ensure that potential investee firms have strong balance sheets, sustainable business models and reasonable growth prospects. However, none of that carries greater weight than the return he's expecting from the dividend over the coming years. Using that one, market-thrashing calculation he boots shares out or buys shares into his fund from his universe of share possibilities.

Too good to miss

The Brexit vote threw up opportunities that he couldn't resist. Woodford reckons that many investors dumped shares in UK-facing cyclical companies and financials in the wake of the referendum on fears of an economic slowdown. He argues that the selling seemed indiscriminate and many firms with decent ongoing prospects were sold down to low valuations without justification. That was a mistake that Woodford used to his advantage by buying shares in those decent firms such as Provident Financial, Legal & General Group, Babcock International Group and Capita Group.

Woodford's dividend calculation informed these investment decisions. He reckons, for example, that Provident Financial featured in his portfolio since its launch and he'd been buying the shares ever since. "We know the business well, we rate its management team highly and we have been consistently impressed with their ability to manage and deliver to investors' expectations," he said. I'm pretty sure that the 'decider' for Mr Woodford was what he said next. "The starting yield is 4.6% and the dividend is expected to grow by 15.9% per annum over the next three years ... a clear indication as to why we have been keen to build this position within the portfolio."

Recent sells include BT Group and BAE Systems. Woodford is worried about pension deficits in the current environment of low interest rates, but the ultimate sell decision came down to the dividend calculation. Although immediate dividend yields remain attractive, modest growth prospects for the firms' dividends means that they are "...no longer as appealing as other businesses in which we have increasing confidence in a more compellingly attractive total return," Woodford said. The dividend calculation appears to have decided the issue once again!

What now?

Neil Woodford's simple but effective dividend calculation has helped steer his fund to outperform the market and it strikes me as a powerful tool to override other investment considerations. One opportunity worth applying the test to is the dividend payer featured in this special Motley Fool report.

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The report sets out a compelling investment thesis, but you can make your own mind up because this research is free and you can download it now. Click here.

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.