The phrase “dogs are a man’s best friend” may be regarded as a cute platitude rather than an immutable fact that you can stake your reputation on, but this is exactly what Stonehage Fleming’s Gerrit Smit (pictured) is doing – by backing pharmaceutical companies that produce drugs for pets rather than humans
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Smit aims to deliver sustainable growth for investors by building a high conviction portfolio of quality businesses. To identify these, he looks for four “pillars”: companies that deliver organic growth, have strong management teams, use capital efficiently and increase free cash-flow on a sustainable basis.
However, he begins with a screen that dispels companies if they fail to match certain criteria, one of which is the sustainability of the sector they operate in. This has led him to avoid pharmaceutical companies – or those that make drugs for humans, anyway.
“The reason for that is obviously the patent cliff, which means your R&D [research and development] will go to waste,” he explained.
“Perhaps you may find a new blockbuster. But if you do, you’ve got another patent cliff, the [barrier to entry] from the R&D only lasts for a while.
“Then along with that, the other major issue is around the concentrated buying power. In every country, the government is by far the largest buyer and they’ve all got one agenda, which is pushing down your prices.
“It was recently in the news that 44 states in America are not threatening, but suing, 20 drug companies because of price collusion. And obviously that means prices are too high. I didn’t want to invest into that.”
Smit said these issues are far less relevant for veterinary medicine. Although such drugs have similar patent lengths, the cost of development is much lower, while a smaller addressable market means producing a low-margin generic drug is less economically viable.
And when it comes to pricing, he pointed out “no government cares about dog medicine”.
However, it is not all about barriers to entry and return on equity – the manager said veterinary medicine is tapping into powerful demographic trends, too.
Growth of pet healthcare spending
Source: Is American pet health care (also) uniquely inefficient? By L Einav, A Finkelstein, A Gupta
“The theme of animal health and how it develops is very much tied in with how wealth spreads through the world,” he continued.
“The more money people have, the more money they spend on their pets. It’s absolutely fascinating. An interesting term that I’d like to mention is by an American company, they don’t talk about pets, the term they use is ‘companion animals’.
“That is exactly what it is. Since we’ve invested, I’ve seen an old lady out walking with her dog after her husband passed away. That little dog is the companion.
“So, you get this issue of people getting older and having these new companions for longer.
“And now I’m seeing young people taking longer before they start with families and actually start with a cat or a dog, a parrot, whatever. And so pet ownership is just exploding. And along with that, obviously the treatment of pets.”
Smit is playing the theme of veterinary medicine in his Stonehage Fleming Global Best Ideas Equity fund through a position in Zoetis, which spun out of Pfizer in 2013. The manager monitored the new company for a number of years before buying in, waiting for it to “settle down”, but it is now the fund’s second largest holding at 5.4 per cent, with Smit calling it one of his best investments.
Zoetis is not the only player in the market. Eli Lilly “split off” Elanco Animal Health last year, but continues to hold an 80 per cent stake, and the new company recently announced a deal to buy Bayer’s veterinary drugs unit.
However, Smit is not planning to buy into Elanco.
“We don’t fear the Elanco-Bayer transaction,” he added. “They are going to struggle to merge the business and find the synergies and these big corporate actions usually take longer to settle down. The Bayer business is actually close to the size of the Elanco business itself, so you can imagine.
“It’s interesting, the Elanco price is dropping. So, we are very happy with Zoetis.”
The manager's portfolio is not completely devoid of human-focused healthcare stocks, although rather than pharmaceuticals, he prefers companies that make equipment for treating patients. One of these is Intuitive Surgical, the maker of the da Vinci robot, which performs minimally invasive surgery.
Smit said he was drawn to this company by the high rates of organic growth it delivered.
“The number to give you is 18 per cent, whereas in Coca-Cola you struggle to get 3 per cent, so that’s a fantastic business.
“An interesting point to make with that is – apart from the quality organic growth in the number of procedures that can be done through robotics – the price the hospital pays for the robot makes up less than 30 per cent of its revenue. Their revenue is actually per procedure and the bits and pieces used for that procedure which are then thrown away and aren’t even used for another procedure.
“Then the servicing of those robots. That is actually the business, rather than just the robots.”
Data from FE Analytics shows Stonehage Fleming Global Best Ideas Equity has made 134.18 per cent since launch in August 2013, compared with gains of 99.52 per cent from the MSCI World index and 78.43 per cent from its IA Global sector.
Performance of fund vs sector and index since launch
Source: FE Analytics
It is $1.1bn in size and has ongoing charges of 0.86 per cent.