If you look around the U.S. market these days you are likely to find the most value from a quantitative perspective in the energy and healthcare sectors. The former area is tricky because the underlying commodity price is so crucial to the profitability of many industry participants. Pipeline owners and large integrated energy plays depend less on the actual commodity price, but because of that you will likely find less value in safer subsets of the industry.
Within the healthcare space, we are seeing a familiar pattern come to the forefront again during the current election cycle. During the 2008 campaign the sector was in focus and saw unjustifiable selling. Back then it was largely centered on the private insurance industry, and this time around bad apples like Valeant have shined a light on drug company practices that sometimes tow a shady line.
Despite many that claim the markets are efficient, history shows us that just because markets go through periods where they shun certain companies, assuming the worst by painting every player with the same brush can be shortsighted. I recall back in 2008 when the health insurance stocks were crushed on fears of what government involvement under President Obama might look like. Many simply assumed that for-profit entities would suffer, without even thinking through what the political goals were and how that would play out in Corporate America.
To address whether the market “always gets it right” during the heat of the battle, let’s briefly revisit the 2008 healthcare scare. The thrust of Obamacare was that Americans would be required to purchase insurance and that said insurance would have a federally mandated minimum level of benefit (no lifetime benefit caps, no exclusions for pre-existing conditions, etc). For a long time investors were so focused on the government getting involved that they missed the big picture. The law required that Americans buy a private health insurance plan. Only on Wall Street would the resulting market reaction be to conclude that this would be a bad development for companies selling those very insurance plans.
Quite logically, the health insurance stocks have been some of the biggest winners during President Obama’s seven-plus years in office. For instance, the iShares U.S. Healthcare Providers (IHF) exchange-traded fund, whose top holdings include all of the largest health insurance companies, has more than doubled in price since January 2008.
Fast forward to current day and we once again have an assault on the healthcare sector, but this time the selling is focused on pharmaceutical companies and their drug pricing, reimbursement, and distribution policies. Unlike the energy sector, there is not a large outside factor beyond the control of company executives that will determine the fate of their financial results. Sure, bone-headed management decisions like those made at Valeant under CEO Michael Pearson will get you in trouble, but that is true for any company in any industry. The idea that every drug company in the country acts just as Valeant has in recent years is ludicrous.
Sure, the ripple effects will be felt across the sector, but the idea that the business model of selling drugs is broken is silly. The U.S. demographic trends only point to more demand in the future. And with more Americans being covered by insurance, there will be plenty of dollars to be spent on treating an aging population.
So where should investors look for bargains? Below are four names that my firm owns in various quantities. If you strip out the noise and focus on underlying cash flow, I think there are plenty of attractively priced drug companies out there. And a year from now when the election cycle is over and the Valeant situation has been rectified one way or the other (bankruptcy or slow recovery back to health), I suspect market participants will get back to basics.
*Allergan (AGN) $225
*Horizon Pharma (HZNP) $16
*Perrigo (PRGO) $100
*Shire (SHPG) $183
All four of these companies look like Valeant in that they have engaged in a lot of M&A activity. In the case of Allergan, they also competed with Valeant for some of those deals. Horizon is smaller company that has grown by acquisition. Two were targeted by larger firms but had deals fall through (Pfizer walked away from a deal to buy Allergan, AbbVie did the same with Shire). Perrigo today announced that its CEO is leaving to replace Pearson at Valeant, after rebuffing a buyout offer from Mylan for $205 per share. Shire quickly pivoted after its failed AbbVie tie-up and agreed to buy Baxalta.
You can see why these stocks are down anywhere from 33% to 60% from their highs. Lots of noisy news flow over the last year. But if you strip all of that out you are left with strong companies with lots of free cash flow generation ability.
Lastly, I think it is important to note that the idea that growing through M&A in the drug sector is a red flag should be reevaluated. Just because Valeant borrowed more than $30 billion and systematically overpaid for acquisitions does not mean that any drug company that acquires other companies is a suspect investment. Consider that the single best launch of a new drug ever was Gilead’s Sovaldi ($10 billion in sales its first year), which was acquired via the acquisition of Pharmasset in 2012. Before that, one of the best-selling drugs of all-time was Pfizer’s Lipitor, which peaked at over $13 billion in annual sales. Lipitor was developed by Warner Lambert, a competitor Pfizer acquired 15 years ago. As with any acquisition, it all comes down to what you get and how much you pay. The idea that investors should shun drug companies that have a history of M&A, without looking any deeper, is strongly misguided.
Full Disclosure: Long shares of Allergan, Horizon, Perrigo, and Shire at the time of writing, but positions may change at any time