This $2.74 Billion Hedge Fund Owns These 3 Stocks

Neil Woodford's newly launched fund, Equity Income, disclosed its top holdings this week, with AstraZeneca, GlaxoSmithKline, and Roche being some of the fund's largest positions. Why?

Jul 12, 2014 at 1:00PM

Playing follow the leader with top investing gurus like Warren Buffett and George Soros can be a profitable strategy. Nonetheless, it's not always apparent why these top notch investors buy particular companies. 

U.K. fund manager Neil Woodford recently launched a fund of his own called Equity Income that raked in £1.6 billion ($2.74 billion) in a mere two weeks during its open period last month.

Although the fund is focused primarily on British-based companies, his top picks in pharma are somewhat surprising and perhaps his outlook for these companies doubly so. Specifically, Woodford made struggling U.K and Swedish drugmaker AstraZeneca (NYSE:AZN) his top holding, composing 8.3% of the fund. GlaxoSmithKline (NYSE:GSK) was his second largest holding at 7.1%, even though the U.K. pharma giant has been mired in marketing controversies and major clinical setbacks of late. 

I find the proportion of these top pharma holdings particularly interesting because they are roughly double the size of his next pharma position, Roche. At least on paper, Roche looks to be a much stronger company in terms of its earnings prospects than either AstraZeneca or GlaxoSmithKline for at least the next few years. With this in mind, let's consider why this closely watched fund manager chose these two pharma stalwarts as his top holdings.

AstraZeneca's falling revenue and rising share price are a bad mix
With blockbusters like Crestor and Nexium coming off of patent protection, AstraZeneca has seen revenues dive off  the so-called patent cliff lately. In the fourth quarter of 2013, AstraZeneca's earnings fell 28% year over year and pretax profit was down by a whopping 57% for the year. Moreover, the company announced at the time that they were unlikely to see revenues return to pre-patent cliff levels until at least 2017.

AZN Chart

AZN data by YCharts

Even so, Pfizer's $118 billion tender offer for the company has driven its share price up a nearly 30% year to date. AstraZeneca shares are thus trading at a princely price to earnings ratio of 45. So no matter how you look at it, AstraZeneca's shares are not cheap at the moment. 

Looking ahead, AstraZeneca is banking, at least partly, on its oncology pipeline to begin to turn things around. But the first drug out of the clinical trial gate stumbled badly. Specifically, an Advisory Committee for the Food and Drug Administration voted 11 to 2 against approving AstraZeneca's experimental ovarian cancer drug olaparib last month. Although oncology drugs tend to have high profit margins and long shelf lives, they also have one of the worst track records in terms of successfully completing a clinical program and subsequently gaining regulatory approval. 

Overall, AstraZeneca does offer a nice dividend that tops 5%, but the negatives would appear to far outweigh the positives. Then again, AstraZeneca's own management sided with this fund manager by stating that Pfizer's bid actually undervalued the company.

GlaxoSmithKline is hard to value right now
British pharma giant GlaxoSmithKline is in a turbulent period in its history. After selling off its oncology assets following a series of clinical failures, the company has taken a larger stake in the low-margin vaccine space. Moreover, generic competition is now demolishing Lovaza's market share and Breo Ellipta sales have been sluggish due to payer issues.

And let's not forget about the high profile Chinese scandal that tagged a top British employee as well. What's most concerning is that Chinese market was a primary reason Glaxo recently started to see an upswing in revenues after two years of declines. Going forward, stricter marketing regulations could dampen growth in China and other emerging markets. 

GSK Chart

GSK data by YCharts

All told, I think it's hard to have confidence in the optimistic forecasts for double-digit top-line growth for Glaxo next year, which is probably the main reason the stock has lagged behind its peers this year.

Foolish wrap-up
While it's impossible to read someone's mind, I think a deeper look into AstraZeneca and Glaxo brings up more questions than answers regarding why a fund would make them top holdings. My view is that they presently only offer two relatively weak reasons to buy: their strong histories of being top pharma companies and high dividends that may or may not be sustainable in light of their falling revenues.

At current levels, I think Glaxo is probably fairly priced and could see improving top-line growth if its new respiratory drugs finally start to take off. AstraZeneca, by contrast, looks ready for a reversal based on its fundamentals and growth prospects. In short, I think there are much better opportunities in health care, so playing following the leader looks like a bad idea this time around. 

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George Budwell has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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