Seeing healthy returns in health-care shares
Even bottom-up stock pickers need to pay attention to the bigger picture. So when global equities sold off last week after the European Central Bank failed to deliver as much stimulus the markets were hoping for, Dennis Mitchell was happy to step in and add to positions in his favourite companies.
“One of the things that started the rout was the disconnect between the ECB’s outlook and the market’s,” the portfolio manager at Sprott Asset Management said.
Unilever PLC is one example of a name that sold off with the rest of the market, but that Mitchell boosted his position in.
One sector that’s been beaten up of late is U.S. health care, whether biotech stocks that came under pressure due to their lofty valuations, only to recover and then pull back again, or pharma companies that are facing scrutiny from politicians due to drug pricing.
This has prompted Mitchell to add to his exposure in the Sprott Global Focused Balance Class, and three other recently-launched funds he manages.
“You want to look at companies that are primarily taking costs out of the system, payers rather than providers,” he said.
“Providers such as hospitals and other facilities aren’t necessarily adding to the problem, but they are in the cost bucket that are trying to be taken out of the system in the U.S.”
Mitchell aims to build concentrated portfolios (35 to 45 names) of high-quality businesses that generate high returns on invested capital, strong recurring free cash flow, have a portfolio of irreplaceable assets, and finance their operations with low leverage.
“Valuation itself is not a catalyst,” he said.
“It makes more sense to buy highquality business that have generated strong returns historically, and offer enough return for the risk you’re taking.”
For example, Mitchell only buys stocks that offer a total return of 15 per cent of more.
Another holding, Medtronic PLC, a medical device company that typically grows its revenues between four and six per cent, appears to fit the bill.
Although its spine business is in a secular decline, the company is innovating and developing new therapies around catheters and drug-coated balloons.
As a result, Mitchell expects it will grow its revenue at 10 per cent over the next three to five years.
The company is also benefiting from a tax inversion following its purchase of U.K.-domiciled Covidien PLC, which freed up $9 billion US of cash that was outside the U.S. this past quarter.
Medtronic thinks it can generate $40 billion of free cash flow in the next five years, roughly half of which is set to be returned to investors in the form of dividend increases, share buybacks or special dividends.
“They can allocate capital to other businesses and grow,” Mitchell said. “It’s also trading at a discount to its health-care peers, so it offers great upside.”
The portfolio manager also has a position in Novartis AG, which is still the largest pharma company in the world until the merger between Pfizer Inc. and Allergan PLV is complete. Like many names in the sector, Novartis faces pressure from generic drugs entering the market.
That’s the case with its cancer drug Gleevec. However, Mitchell noted that Novartis has taken steps to replace its sales with another drug. But what’s most compelling about this story is its pipeline of other drugs, including Entresto, which treats heart conditions and has shown strong efficacy and improvement versus existing drugs.
Mitchell noted that it has “blockbuster” potential, with revenue potential of $5 billion US annually at peak.
Similarly, Cosentyx, which treats severe cases of psoriasis that can cause arthritis, could be another big winner for Novartis.
Mitchell also sees opportunity in Daimler AG, which is held in his global portfolios. While many people point to the auto industry as a sign of strength in the U.S. economy, Mitchell looked to Europe to find a German auto maker that has performed well.
He noted that China, a key market for many luxury auto makers, recently reduced taxes on small and medium-sized businesses, and Daimler has resolved a dispute it had with local dealerships there. “They’ve also put a number of their vehicles on a common platform with common parts, which brings down costs and boosts margins,” Mitchell said. “With a better mix of higher-margin, higher-value vehicles, I expect sales to pick up.”
Look at companies that are primarily taking costs out of the system