A Perfect Storm In Health Care Stocks by Donville Kent
2015 has proven to be a challenging investment environment, as the third quarter saw a sharp decline in equity prices in general and in health care stocks in particular, in which we have significant investments. As of the end of September, the Capital Ideas Fund is now up 3.06%1 for the year while the TSX Total Return Index is down -7.02%2. Year-to-date our returns are decent, but we were up 13.50%3 at the end of the second quarter. Thus, while still up for the year, the Capital Ideas Fund dropped approximately 9.2% in value for the third quarter. This is very frustrating indeed.
The drop in the value of Concordia Health (CXR) from roughly $110 a share in the middle of September to $57 at the end of the month explains most of the drop in the fund in September. The Capital Ideas fund fell -7.03%1 in September while the TSX Total Return Index was down -3.67%2. Excluding CXR, the fund would have been down -1.78%1 in September.
So what happened? First of all, we have owned the stock since its IPO, and our average cost is $10.90 per share. Today’s price is approximately $50.00 per share. Thus, we are sitting on a roughly five bagger today, even after its sudden fall. If we include the stock we have sold over the past year as it has soared above $80 a share, we are probably closer to a seven bagger.
The stock, which had been trading at $90 at the beginning of September, began to move higher as the market started to anticipate that the company was getting close to making a significant acquisition. Sure enough, CXR announced in mid-September that it was acquiring Amdipharm at an attractive valuation subject to financing. So far, everything looked great.
At the same time that CXR was announcing its deal, however, the US Health Care sector was correcting sharply, and US Secretary of State Hillary Clinton announced her intention to crack down on pharmaceutical companies that were over-charging their clients. CXR was therefore trying to complete its financing as its stock, along with that of the rest of the healthcare sector, was falling sharply.
This was a perfect storm. As the stock was falling, investors who had bought the stock on margin started getting margin calls. The sell-off of CXR stock accelerated further, not because there was anything wrong with the company, but because those who had bought the stock on margin had no choice. They had to sell.
So, where to from here? CXR has completed its equity issue and its underlying businesses are strong. But we also know the company is carrying more debt than we would like. Going forward, we think the stock is still quite undervalued but the company will need to address its debt issue somewhere down the road. This could mean that the company raises more equity or puts itself up for sale. Regardless, at current valuations, I think the company is worth a lot more than $50 a share. On our numbers, CXR trades on 4.8x 2016 Cash Earnings and 1.1x BVPS, while earning a 24% ROE.
Thoughts on Healthcare
Notwithstanding the recent sharp correction in healthcare stocks, we continue to view the sector as one of the great growth arenas in today’s stock market. The lack of growth in many Western countries can be explained by an aging population profile, which means that the demand for most items provided by the health care system, from drugs to outpatient services, will grow sharply in the coming years. The healthcare sector offers some of the highest margin and highest growth companies on the TSX. Following the correction, many of these companies including CXR, are trading at below market PE ratios. While share price volatility of the past few months has been a bit overwhelming, the underlying growth profile of the sector in general, and the companies we own in particular, has not changed.
It’s been a tough quarter. For the past two years many of the sell-offs in key sectors of the stock market occurred in sectors in which we had little or no investments. The third quarter was the first time in a while we saw a sharp correction in a sector in which we are a significant investor. I remain committed to the health care sector because I can see that the growth opportunities are immense, while valuations are reasonable. This might mean that you and I will need to endure a bit more volatility in the future than we did in the past, but I am pretty certain the rewards will be worth it.
Thanks as always to my wonderful team and my patient investors.
Write me if you want to chat – J.P. Donville
1 Time weighted rates of return for Class A Series 1, net of all fees and expenses as of September 30, 2015
2 S&P TSX Composite Total Return Index is the Net Total Return version of the S&P/TSX Composite Index
3 Time weighted rates of return for Class A Series 1, net of all fees and expenses as of June 30, 2015