Bronte Amalthea Fund commentary for the month ended December 31, 2016.
In December the fund significantly outperformed strong global markets in both absolute and relative terms. Our longs generated the gains and performed better than the market whilst our substantial short position was neutral which is unusually favourable in such a strong month.
This being the end of the quarter we provide a lengthier commentary in two sections. In the first we present a detailed discussion of a new long added in the quarter, which is Bayer. Second, in something of a departure for us, we offer some macro commentary that explains the positioning we have built from our micro-level research.
Bronte Amalthea Fund – Bayer
We have added one new big position to the portfolio in the last quarter. We now hold a 5 percent position in Bayer – the largest company in the German index. Bayer has four and half businesses which they collectively call “life sciences” but in fact fit into no specialist portfolio.
These businesses are:
(a) A large second tier pharmaceutical company which has a few major drugs, on which they have partnered,
(b) A large over-the-counter (OTC) medical products business – which they (plausibly) argue is the biggest in the world,
(c) A moderately large seed technology business
(d) A moderately large animal health business.
The half business is a majority stake in Covestro – Bayer’s old materials business.
The whole contraption trades for between 2 and 2.5 times revenue depending on how you net out Covestra. This is really cheap for this type of businesses. Ultimately most of these are pretty good businesses that earn high margins, should earn even higher margins and normally trade at bigger multiples.
The main knock on the stock is that they are buying Monsanto to create by far the biggest seed technology business in the world. They are paying well over 4 times revenue for Monsanto. It is far from obvious financially why they should do this acquisition.
Moreover, it is pretty clear that the market hates this deal. This is now too big a seed technology business to attract pharmaceutical focused investors. Monsanto is a company that sells genetically modified seeds (unpopular in Europe) and pesticides (also unpopular) and sues farmers for not paying seed royalties (unpopular everywhere).
As far as the market is concerned this is a big bad deal.
The businesses and comparisons
Bayer is a genuinely large pharmaceutical company. The right valuation comparison is the mega-giants. Pfizer trades at 4.2 times sales. Novartis trades at 4.1 times sales. We could go on. Most pharmaceutical companies trade above 4 times sales.
Bayer has big advantages over many of these companies – most of its key patents have a lot of years left to run, and it has a decent pipeline. The drugs have obvious revenue growth.
The biggest problem is that the two main drugs have issues, one essentially legal, and the other potential low cost competition.
The two biggest drugs are Xarelto and rights to Eylea which they share with other companies.
Xarelto is a Warfarin substitute. Warfarin is an old drug – out of patent and cheap. It is a blood thinner – and reduces stroke risk and other risks particularly in old people. It is very widely prescribed (including maybe 10 percent of the population of the Western world over the age of 80). And it causes considerable problems.
Dosing is tricky. The difference between an effective dose and a dangerous dose is small and variable. If you give someone too large a dose they can get internal bleeding (especially internal bleeding in the brain) and die. In fact it is pretty good at causing death, and so Warfarin is also used as rat poison.
Warfarin has one big advantage as a blood thinner and as a rat poison. There is a cheap, easily available antidote – just a big injection of Vitamin K along with some plasma.
Xarelto has big advantages over Warfarin. Most importantly the dosing is easier. It is just easier for a general practitioner to get dosage right and hence the doctor is less likely to kill the patient. This is an enormous selling point and makes Xarelto a drug of choice outside hospital settings.
Secondly it is claimed that Xarelto preferentially causes bleeding in the intestine (where it is passed and noticed) rather than in the brain (where it unnoticed and very dangerous).
There is one big disadvantage over Warfarin: there is no antidote.
The big problem with this drug though is that it is a blood thinner – it will cause internal bleeding, and that will cause death and/or brain damage. If you sell these things you must expect considerable litigation costs even if, on average, they do considerable good.
The second important drug is Eylea – a treatment for wet age-related macular degeneration.
Wet AMD is a leading cause of blindness in old people – and stopping people going blind is a good formula for getting very high prices for your drug. If your drug stops people going blind it has huge economic benefits and medical systems (even government funded ones like Australia) will pay a lot for this.
Now let’s get past the squeamish bit. This works by monthly injections in the eye. That treatment regime means that non-compliance is high (even though noncompliance leads to blindness).
But alas the story gets more complex. There is a relatively old cancer treatment drug that stops the body making more capillaries. The drug is Avastin and it is marketed by Genentech (a subsidiary of Roche). It is a very important cancer drug – the idea being that you zap the tumor with radiotherapy or similar and then give Avastin to stop new capillary formation and hence the regrowth of the tumor.
If you inject Avastin in very small quantities in the eye on a monthly cycle you will slow the development of Wet AMD.
The problem from the drug company perspective is that very small doses of Avastin are cheap (maybe $50). And this is a treatment the drug company really believes they should be paid for.
So Genentech came up with a very similar drug (Lucentis) which works the same way as Avastin and which they tested as a treatment for Wet AMD. It works.
They charge a large amount for it (about $24,000 a year or $2,000 an injection).
They never subjected Avastin to a proper double-blind study. As Avastin is not “proved” to be effective it is not prescribed – and so Genentech gets lots of extra money from selling Lucentis instead.
Eylea is yet another version of the drug developed by Regeneron (listed in the US) and Bayer. It also gets a lot of money and is priced about the same as Lucentis.
Whether these prices are sustainable is open for debate. Genentech are hardly going to offer up their cheaper drug by subjecting it to an expensive double-blind trial. When we looked at the treatment regime subsidized by the Australian government we found only Lucentis and Eylea. Avastin was not allowed. Concerningly however, some European governments dictate Avastin.
Again this is a really profitable business – we are not entirely sure how sustainable. But the Australian