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Quotidian Investments Monthly Commentary – November 2015

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December 14, 2015

Following the years of global depression from 2007 onwards corporate profit margins have frequently been shored-up by a combination of:

  1. Cost-cutting
  2. A premeditated lack of investment in capital equipment
  3. Record levels of share buybacks by public companies

However, there is a limit to the enduring effectiveness of profit growth using just these measures. Financial engineering of this sort eventually suffers from diminishing returns and so growth in sales is vital in order to boost real long-term earnings growth.

From an investment perspective it thus remains critically important to focus on which sectors and individual stocks are still capable of growing their sales and thereby their profits. It is equally important, of course, to avoid those companies and sectors which cannot or will not do so.

With that in mind, the sectors that we expect to contribute the most and the least to third-quarter results and thereafter are:

The good: Healthcare stocks are expected to report increasing sales up 8% on average from a year ago with earnings per share advancing over 6%. Consumer Goods and Services are also expected to deliver earnings increasing by 5% for the quarter with profit growth of 4%. Technology stocks are the other positive sector.

The bad: Earnings growth for S&P 500 Industrial Sector stocks has been declining for the past two quarters (hand in glove with weaknesses in energy and commodity prices) and profits in this sector are anticipated to decline by over 5% in the third quarter.

The ugly: The worst offenders this quarter will continue to be Energy and Basic Materials stocks. We anticipate that falling oil and gas prices together with continuing declines in many other commodities will bring about dismal results in these sectors both in this quarter and beyond. Energy stocks in the S&P 500 are expected to post a 64% earnings decline on average this quarter while Basic Materials profits are forecast to drop by 18.5%.

The Quotidian Fund places a considerable focus on the Healthcare, Pharmaceutical and Biotechnology sector.

The attraction of this sector from an investment viewpoint is that it has:

  • A long history of relative security and reliable performance;
  • Projections of future profits are consistently robust;
  • Takeovers are commonplace and so there is potential for an occasional huge increase in share prices;
  • Also, on a non-financial but equally important basis, by supporting the development of new medicines we contribute towards a valuable social benefit too.

In the pharmaceutical and biotech sector there are broadly two styles of business model:

  • Companies that spend billions on research & development to produce new drugs
  • Organisations that are simply opportunistic and seek to buy the rights to various drugs which are towards the end of their patent protection period and then ramp up their prices to maximise short-term gains.

We fish in the former pond but not the latter. Companies who create new drugs are able to acquire patent protection on these products which allows them to recoup the costs of development and rightly gain worthwhile profit from their enterprise. Typically, patent protection lasts for 10 years following which any drug can be copied and marketed by all and sundry. It follows that the first ten years from launch of a newly approved drug are the most important and lucrative from the innovating company’s viewpoint.

Opportunistic organisations do have their place as they allow those who are focused on research and development to capitalize the inherent value remaining in those drugs that are approaching the end of their patent protected period and thus direct that value into future R & D.

Companies like Valeant Pharmaceuticals (a Canadian company) are increasingly coming under fire. Their business model focuses on buying well established drugs and then hiking the prices of those drugs massively. They then distributing the resultant profits to management and shareholders rather than investing in Research & Development.

For example, we note that Valeant quadrupled the price of a drug called Cuprimine. The effect was to drive up the cost of just one patient’s treatment to $35,000 a month – a five-fold increase largely covered by Medicare (thus the political hand-wringing and backlash in the USA).

In addition, late last month the industry found another pantomime villain in the form of Martin Shkreli. His company, Turing Pharmaceuticals, bought the rights to a drug called Daraprim which treats an infection called toxoplasmosis. Turing then proceeded to ramp up the price of that drug by more than 5000%.

There are many sides to this issue but soaring drug prices raise widespread ethical, political and social concerns. The current negative publicity has clearly put short-term downside pressure on pharmaceutical stocks in general and biotech stocks in particular.

This is what gave rise to Hillary Clinton’s recent knee-jerk reaction and politically self-interested ‘soundbite’ last month (as covered in my September monthly report). As a consequence of that investors have been concerned that the US government could introduce price controls or other punitive measures on pharmaceutical and biotech companies.

In our opinion this action is highly unlikely because to do so would stifle the development of new drugs and treatments which would, of course, be politically unpopular and morally bankrupt. Innovative companies spend billions on R&D to take a drug concept through the various stages of rigorous testing in order to get FDA approval. Naturally therefore their breakthrough drugs need to be sold at an appropriate and profitable price. Political interference has acted as a drag on the sector at this point in time but we believe that this effect will be short-lived.

On 31st October the FTSE 100 closed at 6361 (which equates to -3.12% for 2015 to date). This represents an uplift of 4.94% during its partial recovery month of October.

By comparison the Quotidian Fund at the end of October was +18.89% for the year to date, having increased in value by +8.88% in the month. We currently stand exactly 22.00% ahead of our benchmark (being the FTSE100 index).

During this exceptional month we have regained virtually all the value that had been marked down during the lacklustre and volatile months of August and September. It is vitally essential not to panic and risk making emotional decisions when markets go through such potentially unnerving periods of negativity.

Our performance in October partly reflects the bounce-back effect of major markets after two months of profoundly negative market correction. To a greater extent though it is a reflection of the positive and considered actions we took at the low points in markets to increase our holdings in those companies we trust whilst their prices had been oversold and, in addition, to building up well-thought-out new holdings up at fire-sale prices.

It has been helpful that the third quarter reporting season (thus far roughly 60% of the companies which form the S&P 500 index have released their latest figures) has produced far more positive surprises than analysts had expected. Future sales and earnings estimates have also been generally encouraging.

Stockmarkets were given further positive momentum in the last ten days of October by the European Central Bank’s announcement that it intends to expand and extend its quantitative easing programme and also by the Peoples Bank of China’s action in reducing interest rates there by a further 0.25% whilst simultaneously easing liquidity requirements for their banks.

An additional air of positivity was engendered when the Federal Reserve issued an upbeat report in respect of the US economy on 28th October and suggested that they might now introduce their long expected interest rate increase in December. As anticipated in our September report, this has been well received by markets.

We are under no illusion that the global economy generally remains in very poor shape with worrying levels of corporate and sovereign indebtedness that by any recognised economic measure are beyond parody.

However, there are always individual companies and sectors that rise above the prevailing gloom and continue to produce relatively reliable profits on a regular basis. These, of course, are where we seek to focus our efforts.

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