Jul, 27, 2017

Scorecard #19 – Twin Pandemics

Twin Pandemics

The Value Fund was down (0.13%) in the second quarter and is up 2.82% year to date. The continued weakening of the US dollar and our US-centric holdings have held back our returns when measured in Canadian dollars (the Value Fund’s reporting currency).

Our best performers for Q2 by portfolio contribution were Novo Nordisk +25.1% (discussed in detail on page 2), American Express +6.5% and Anthem +13.8%. Our biggest laggards were IBM (11.7%) and Chevron (7.4%).

Notes:  All returns and Value Fund details are as of June 30, 2017, based on Class A units and are net of all fees.  The Value Fund was launched on November 1, 2011. Prior to January 17, 2014 the Value Fund was managed by Lightwater Partners Ltd. while Mr. McCloskey was employed by that firm.


“The intelligent investor is a realist who sells to optimists and buys from pessimists.”

Benjamin Graham


The Intelligent Investor


We are finding a few underpriced situations these days and made a timely addition of a new consumer discretionary stock to the Value Fund in Q2.  Solid earnings followed and we are off to a good start.  As we may still accumulate additional shares, we will disclose this new holding in a future letter.  During the quarter we fully exited our holdings in Express Scripts (NYSE:ESRX).  We had assumed that the company would be unable to renew its largest customer – Anthem (NYSE:ANTM) – when the contract comes up for renewal in 2020.  However, we underestimated how profitable that contract was to the company which they finally disclosed to the market.  Based on previous communications with the company’s management, we felt misled on that point.  Having profitably trimmed our holdings previously, we ended up with a small loss on our overall investment in the company.

We also fully exited our holdings in Bed, Bath & Beyond (Nasdaq:BBBY).  The juggernaut that is Amazon (Nasdaq:AMZN) is making life difficult for most retailers these days.  While Bed, Bath & Beyond remains very cheap by conventional metrics (6.9x trailing P/E as of the date of writing), we believe that their moat is being drained and their future profitability at risk due to changing consumer shopping habits.  Given our initial assessment of the risks involved, our position size was always modest at less than 3.5% of the portfolio.  Overall our investment cost us (0.35%) of performance.  The lesson learned: determining the durability of the competitive advantage(s) of our investee companies is incredibly important.  Chalk this one up to experience.


Novo Nordisk A/S (NYSE:NVO)  


Value Fund holding Novo Nordisk is the world leader in diabetes care with a global market share of 27% by value (46% by insulin volume). The company was founded in 1925 and is headquartered in Denmark.  However, its origins have a uniquely Canadian connection.

In the early 1920s, Dr. Frederick Banting and Charles Best conducted pioneering research on animal pancreases at the University of Toronto.  Their research eventually led to the discovery of insulin and earned Dr. Banting the 1923 Nobel Prize in Medicine.  Prior to their discovery, the treatment of diabetes consisted of a severely restricted diet which usually led to death within a year or two of diagnosis.  And while a cure for diabetes remains elusive to this day, the advent of insulin has dramatically improved both life expectancy and quality of life for those stricken with the illness.

Dr. Banting and his colleagues patented their invention but considered the idea of profitable commercialization unseemly.  Their goal was to make their life-changing invention safely available to as many diabetics as possible.  Consequently, they sold their patent to the University of Toronto for $1 (you read that right).  However, it quickly became apparent that the University did not have the ability to produce insulin in the quantities needed to meet the growing demand.  Ultimately commercial licenses were granted to several pharmaceutical companies including a predecessor to Novo Nordisk.

Novo Nordisk’s Economic Moat

Fast forward almost a century and today the diabetes industry is dominated by a three-firm oligopoly consisting of Novo Nordisk, Eli Lilly (NYSE:LLY) and Value Fund holding Sanofi SA (NYSE:SNY).  These three companies have managed to continually innovate by creating more effective and safer iterations of insulin and delivery devices that benefit diabetics.  Each new innovation also gives them additional patent protection which has kept potential competitors at bay and allowed them to continually increase prices.

The economic moat enjoyed by the “Big 3” extends beyond mere patent protection.  The manufacture of insulin is a complex process involving trade secrets and a significant initial investment in manufacturing facilities.  For example, Novo Nordisk will spend US$1.5 billion this year to expand its production facilities in the US and Europe.  In addition, insulin is manufactured biologically.  Unlike small-molecule pharmaceuticals (most drugs), the molecular structure of biologics is large and complex as they are derived from living sources.  Biological “copies” are not identical, they are merely bio-similar.  This is a relatively new area of medicine and the regulatory framework is still evolving such that getting a biosimilar approved is more complicated than with generic drugs.  Given the complexity of manufacture, discounting on biosimilars is unlikely to be as aggressive as with traditional drugs thus limiting pricing pressure.


The advantage of scale production and the need for scale in distribution (Novo Nordisk has a sales force of 16,000+) lends itself to an industry with just a few, large competitors.

Finally, once a diabetic finds an insulin that works well for them, they tend to stick with the same brand creating a consumer switching cost that locks in customers. The longstanding reputation (brand) of these companies also helps to perpetuate the status quo.  Doctors and their patients want to know that they can trust the quality of the insulin being injected.

Limited competition, patent protection, brands, customer switching costs and barriers to entry – combine them all and you can understand why the Big 3 have enjoyed pricing power and have been able to increase prices frequently.  The result?  Novo Nordisk enjoys 85% gross margins, 42% operating margins and returns on equity approaching 100%.  This is an incredible business.

The Opportunity / Investment Thesis

Novo Nordisk has a debt-free balance sheet, net cash of US$1.08 per share and pays a healthy dividend.   Historically, Novo Nordisk has traded at price-to-earnings multiples over 20x.    But the stock has had a major selloff due to two cuts to profit guidance which led to recent management changes.  The company’s current (lowered) guidance is for annual operating profit growth of at least 5% (down from its historical 15%).

The company’s recent stumbles were caused by pharmacy benefit managers (PBMs), governments and other payers in the US using their growing clout to aggressively demand discounts and play off the Big 3 against each other or risk formulary exclusion.   In addition, biosimilar products are slowly but surely being introduced to the market.  This changing dynamic makes it increasingly critical for the Big 3 to make meaningful improvements to next-generation insulins in order to continue to demand premium prices.

Despite improvements in the treatment of diabetes, it remains a global pandemic.  According to the World Health Organization (WHO), over 422 million people worldwide suffer from the disease.  And as populations age in developed economies and improving standards of living lead to greater obesity levels in developing countries, the number of type 2 diabetics in particular will continue to grow.  As a result, the Big 3 will have a huge tailwind at their back for many years to come.

Novo Nordisk gets solid marks for shareholder-friendly capital allocation.  The company is a prodigious generator of free cash flow and has a demonstrated track record of returning almost all that money to shareholders through a combination of dividends and share repurchases.

Novo Nordisk’s shares trade on a number of European exchanges however we prefer to own the American Depository Receipts (ADRs) that trade on the New York Stock Exchange (NYSE:NVO). We started accumulating shares in the Value Fund beginning in late 2016 and added to our position on several occasions in 2017.  Our holdings in the company represented approximately 4.6% of the portfolio at June 30.

With an average cost of US$35.89 per ADR (or 229 Danish Kroner per share) we were able to buy the stock at a below-market 15x earnings multiple – in our minds a bargain for an above-average company likely to grow faster than both the economy and most companies.  We are currently up +19.5% on our investment however it is far too early to declare victory.  We anticipate that our investment thesis will play out over many quarters (and years).  Given Novo Nordisk’s business economics, history of continual innovation and success at managing the business over the past 92 years, we like our chances.


Exchange-Traded Funds (ETFs)


“What the wise do in the beginning, fools do in the end.”


Warren Buffett


We are bombarded daily with advertisements for the latest iteration of exchange-traded funds (ETFs).  Created by Vanguard pioneer Jack Bogle back in 1976, the concept has more than taken on a life of its own.  I am often asked for my opinion on ETFs which I can boil down to a few salient points.

Select high-quality ETFs can have a place in any equity investor’s portfolio.  But most investors don’t understand what they are buying or that the major market indices that many track are price weighted.  In other words, the more expensive a stock, the more of it you end up owning in an index-ETF.  This is the exact opposite of our more rational value investing approach.  As stocks sell off they actually become more attractive, not less so.  We think that the next major market correction, whenever it comes, will bring a few unpleasant surprises to ETF holders.

Secondly, there are a lot of poor-quality companies out there that we prefer to avoid.  For example, at its peak valuation, Valeant Pharmaceuticals (TSX:VRX) accounted for 6.1% of Canada’s S&P/TSX Composite Index.  Shades of Nortel circa 2000.  Again, we prefer to mitigate investment risk by owning high-quality businesses at undervalued prices and avoid the rest.

Finally, diabetes isn’t the only pandemic currently spreading around the globe.  As the Oracle so aptly put it: “What the wise do in the beginning, fools do in the end.”   Do investors really need a Global X Millennials Thematic ETF (NASDAQ:MILN), a tiny $6 million fund that targets companies that they deem attractive to Millennials?  Or how about the Nashville Area ETF (NYSE:NASH) which owns diverse companies that happen to be located in Nashville, Tennessee?  No doubt there will be additional thematic and multi-leveraged ETFs coming to market in the near future.  Whenever there is market demand, the investment industry is sure to keep feeding it while it lasts.  We would also posit that these are vehicles for speculation, not investing.

Okay, rant over.  But I should mention that instead of investing via ETFs, I prefer to invest my own money directly alongside GreensKeeper’s clients (in my case, over 70% of my family’s net worth and 100% of our investible assets). We are believers in capital preservation and disciplined practitioners of a time-tested valuing investing methodology that should be a component of every investor’s portfolio.

In short, we are different.  If you are interested in learning more over coffee at our Oakville office or downtown Toronto, feel free to give me a call.

Michael McCloskey

President & Founder

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