Sep, 11, 2014

Scorecard #10 – Steady Progress

Steady Progress

As of August 31, 2014, the Value Fund is up +10.9% in 2014, 18.5% over the past 12 months and 43.2% since inception (all figures are after fees and expenses).

Since inception, we have managed to beat the S&P/TSX Index and have lagged the major US indices. Our preservation of capital mindset and a measured deployment of our initial cash position in a rising market held us back somewhat early on. However, we have since made steady progress. The investment game is a long one.

Long term we believe that we will continue to deliver attractive returns for our clients while thoughtfully managing risk and preserving capital.


Express Scripts Holding Company (Nasdaq:ESRX)

A fellow Globe & Mail columnist recently pointed out that many Canadian portfolios suffer from “home bias” (an overexposure to Canadian equities). We have a prescriptive solution.

Express Scripts Holding Company (Nasdaq:ESRX) is the largest pharmacy benefit management (PBM) company in North America. It serves thousands of clients including managed‐care organizations, insurance carriers, employers, third‐party administrators, public sector and union sponsored benefit plans.

The PBM industry is an obscure one and one that most people are unfamiliar with. PBM services include network pharmacy claims processing, home delivery services, benefit‐design consultation, drug‐utilization review, formulary management as well as medical and drug data analysis services.

Health care spending in North America continues to grow at rates well in excess of inflation and consume an ever larger share of GDP. Payers retain PBMs to help control their spending on prescription drugs. Improved patient outcomes through monitoring and error reduction are an added bonus.

Express Scripts uses its scale (the company processes 1.4 billion prescriptions a year) to negotiate favourable rates with pharmacies, pharmaceutical manufacturers, drug wholesalers and others in the drug supply chain. The company passes along most of the savings to its clients and keeps a sliver of profit from each script for itself (currently about US$5.50 per script). The size of that sliver keeps growing each year due to the operating leverage inherent in the business as the cost of processing an additional script for an existing customer is very low.

The long‐term fundamentals of the PBM industry are attractive. An aging demographic provides a tailwind as drug usage will continue to climb thereby increasing the need to find ways to reduce healthcare costs. Annual drug price inflation also works in a PBM’s favour.

Given the scale needed to succeed, over time the PBM industry has consolidated with a few dominant firms controlling most of the market. High customer switching costs and regulatory complexity also help these companies to continually widen their economic moats.

Express Scripts does have competitors ‐ CVS Caremark (NYSE:CVS) and Catamaran Corp. (TSX:CCT) to name a few ‐ and contracts are typically put out to bid at renewal. However, we suspect that the request for proposal process is largely used as a means of keeping the incumbent’s pricing in check. PBMs are difficult to displace as evidenced by client retention rates that routinely exceed 95%.

Express Scripts cemented its leading position in the PBM industry with the US$29.1 billion acquisition of competitor Medco Health Solutions in 2012. However the acquisition came with a cost.

Integration efforts have taken time, distracted the company’s employees and led to higher than normal customer turnover as client retention fell to 92%. This is now largely behind Express Scripts and the company’s execution should improve going forward.


Acquisition accounting from the Medco and other transactions also gave rise to non‐cash charges that reduce reported net income and understate the company’s true earnings. We believe that the company’s estimated free cash flow of over US$5.50 per share in 2014 is more representative of its true owner earnings.

Management’s guidance to deliver 10%‐20% annual earnings per share growth over the long‐term appears reasonable to us given their historical track record.

At our recent purchase price of US$68.66 (less than 9 times pre‐tax earnings) we viewed the stock as undervalued. Despite the stock’s recent move higher (US$74.55), we still believe the stock is worth purchasing. Management seems to share our view as the company has repurchased over US$6.7 billion worth of stock over the past year and a half and reduced the outstanding share count by 9% all while maintaining the company’s investment‐ grade rating.


Closer to home, we could have invested in Catamaran Corp. ‐ a TSX‐listed PBM. However, we prefer to invest based on the quality of the business and the attractiveness of the purchase price, not geography. When you can invest in the industry leader at a discount to both its competitors and the overall market, in our minds the preferred choice is clear: buy quality when it is on sale.

The geography of the company involved does matter but for a different reason than you may think. Our investment approach is to invest in great companies domiciled and operating primarily in shareholder‐friendly jurisdictions. Canada, the United States and Western Europe all meet this test. We believe that supremacy of the rule of law combined with their global operations provides a lower risk method of gaining exposure to faster growing developing economies.

History Rhymes

Since our last newsletter the market has continued its upward climb making bargains even more difficult to find. However, we have managed to find a few quality names like Express Scripts that were selling at a discount.

IPOs of lesser quality continue to come to market, some at mind‐boggling valuations. Debt covenants soften while overall leverage ratios creep higher. Historically this has not ended well.

In light of the market environment and the wise words (at top left) of someone that knows a thing or two about investment history, we will continue to own quality and remain patient for opportunities when they present themselves.

You should know that this view is not merely academic. I have over 70% of my immediate family’s net worth invested alongside GreensKeeper’s clients and I invest our clients capital as I do my own. Long‐term, our capital preservation mindset should continue to serve us well.

Michael McCloskey

Founder & President

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