Why Woodford Is Defensive — And Why AstraZenca plc, GlaxoSmithKline plc And British American Tobacco plc Are His Biggest Holdings

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In a new blog post entitled ‘The Turning Tide’, Neil Woodford highlights the precarious nature of markets in the current environment. Neatly combining two well-worn nautical analogies, he identifies QE and easy money as the rising tide that has floated all boats – boosting stocks across the board. As QE is withdrawn the gap between valuations and fundamentals will close. Quoting Warren Buffett, he warns that “you only find out who is swimming naked when the tide goes out.

Heading for a fall

In other words, markets could be heading for a fall. Whilst stocks have generally been rising over the past five years, he sees the next five as a stock-picker’s market which favours “a fundamental investment approach and a cautious investment strategy.”

That analysis casts a new and interesting light on the highly defensive nature of Mr Woodford’s fund portfolio – and chimes with what many of us at The Fool have been saying. Nearly 60% of Mr Woodford’s new fund is invested in classic defensive sectors such as health care, tobacco and utilities.

Two concepts

Let’s be clear — and forensic — here: Mr Woodford has chosen his words carefully. “A fundamental investment approach and a cautious investment strategy” covers two distinct concepts. A cautious investment strategy inevitably means skewing towards defensive stocks: as the tide falls, all stocks fall, but defensive shares less so.

Taking a fundamental investment approach means examining the fundamental worth of individual stocks. You should only hold shares in which you have high conviction. High PEs and ‘story stocks’ are most at danger. Some of the recent IPO stocks could see their valuations reassessed once the tide goes out.

Defensive stocks

Mr Woodford’s top three holdings illustrate his defensive stance. AstraZeneca (LSE: AZN) (NYSE: AZN.US) and GlaxoSmithKline (LSE: GSK) (NYSE: GSK) together make up 15% of the fund. With GSK over its patent cliff and Astra’s pipeline looking ever more promising, both companies enjoy the defensive qualities of the pharmaceutical sector. Demand is underpinned by health care expectations of an ageing (in the West) and wealthier (in the East) population, whilst technological barriers to new competitors are immense.

The defensive nature of third-largest holding British American Tobacco (LSE: BATS) derives from the addictive nature of its products. The prospects for the sector are of long, slow decline — unless disrupted or revived by e-cigarettes — but it’s possible to milk cash and dividends for many years from mature, consolidating industries. BAT’s position in emerging markets gives it an edge in longevity.

What next?

Mr Woodford freely admits that he doesn’t really know what will happen when QE ends: “Only time will tell.” In that, we’re all in the same boat. You can’t predict the future — you can only best position yourself for what might happen.

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Tony Reading owns shares in GlaxoSmithKline. The Motley Fool recommends GlaxoSmithKline.