Two fund managers have warned that analysts should be calling the top of certain parts of the biotech market, even though this is the area their investment trust is focused on.
Paul Major and Brett Darke run the BB Healthcare Trust, which has benefited from the market’s focus on pharmaceuticals, biotech and patient care since the outbreak of the coronavirus pandemic, making close to 60 per cent in the 18 months to the start of May.
Performance of trust vs sector and index Nov 2019 - May 2021
Source: FE Analytics
Yet they have sold out of many of the stocks responsible for this performance, warning “fundamentals and valuation seem increasingly abstract concepts to Wall Street analysts”.
“The pandemic has been a dislocating event for investors but, at some point, the market should return to thinking about the normal reality of life and, attendant to this, the appropriate multiples to pay for growth in certain areas of the market,” they said.
“Inasmuch as life still feels far from ‘normal’, the long-term consequences of the pandemic in the context of healthcare consumption are very limited. People will still get sick as they did before, with the same types of maladies, and society will continue to struggle to manage the burden of an aging population. As such, the price of growth in any given sub-sector of healthcare should not really be very different to today.”
They added: “Post pandemic, a pen is still just a pen. Unless the sedulous sell-side analyst chooses to bestow upon it heretofore recondite qualities. Alternatively, one might not notice a company has become absurdly overvalued due to the lack of, say, a robust financial model to allow one to discern such a point.”
Major and Darke said both circumstances have become “irritatingly frequent occurrences” over the past year and they have lost track of the number of times an analyst has told them “you don’t understand” when they asked for an explanation of why a stock’s price target has gone up 5 or 10x within a couple of years.
They said this flies in the face of proven investment principles, summed up by Benjamin Graham’s quote that “the stock market tends toward being a rational weighing machine” over the long term.
What most frustrates them is these are not distressed assets, but quality companies in a sector with huge long-term opportunities. Yet the managers warned this doesn’t mean investors can afford to turn their back on valuations, which a growing number appear to be doing.
They said this may be an unfortunate side effect of the industry’s recent focus on giving customers ‘value for money’.
“These days, lots of people talk about fees and expense ratios and driving down costs in asset management,” they continued.
“This is not unreasonable, but there is a value chain. Less money in asset management means less money paid to brokers. They respond by cutting costs and refocusing their efforts towards hedge fund clients who are still happy to pay handsome fees. In research, this has resulted in widespread ‘juniorisation’.
“A senior analyst now covers ever more companies as a ‘name’, but actually has an army of less experienced people doing the work because no one on the sell-side can really cover more than a handful of companies alone because every event requires the publication of a note, no matter how immaterial that event might be.
“There is so much unnecessary reportage required. The buy-side is blissfully free of such constraints.”
Major and Darke said this means there is less time for the type of detailed analysis they feel is essential for working out the true value of an investment. It also helps to explain why their view has diverged from the rest of the sector on what were two of their biggest holdings just 18 months ago: medical device company Align Technology, which was their second-largest position at 7 per cent, and telemedicine service Teladoc, which was their fourth-largest position at 6.3 per cent.
With Align, the shares were trading at $277 back in November 2019 and the managers forecasted 2022 revenues of $3.7bn. Consensus revenues for 2022 now stand at $4.6bn, 27 per cent higher than their forecast, and profits are expected to be 50 per cent higher; but the shares stand at $578, 109 per cent higher.
“Align has fared much better than we feared through the pandemic, but we now struggle with the fact it is trading on 1.5x the forward multiples that prevailed at the end of 2019 and also that it can generate that much revenue in 2022, since the competitive dynamic is not obviously different to what it was before,” they said.
“This is a company we would be happy to own again, but only at the right price; one that takes account of the discretionary consumer-oriented nature of its business and the hyper-competitive environment. These concerns are a rarely cited now; on the recommendation side, we see 11 ‘buys’, three ‘neutrals’ and only two ‘sells’.”
With Teladoc, the shares were trading at $84 in November 2019 and the managers forecasted 2022 revenues of $1.1bn (or $1.7bn when consensus expectations for Livongo were added in, which Teladoc acquired in 2020).
Major and Darke didn’t like the Livongo business, so they sold their remaining holding in July 2020 at what they described as an “already silly share price of $190”.
Today, the 2022 revenue expectations stand at $2bn and EBITDA is 2x higher than the managers’ forecast, but they have some reservations over its ability to meet these aims.
“Teladoc is indisputably the Rolls Royce of telemedicine tech,” they continued. “However, one need not walk far to realise that most people don’t drive a Rolls and couldn’t justify buying one.
“Meanwhile, the number of cheaper alternative options continues to mushroom, driven by the pandemic catalysing a huge uptick in investment targeted at developing similar solutions by existing and new players. Today, the shares stand at $159, not far above where we averaged out of our holding.”
The managers said they may consider buying Teladoc’s shares again if they fell to double digits, but they are almost alone in this view, with Bloomberg suggesting 22 ‘buys’, 10 ‘neutrals’ and only one ‘sell’ recommendation.
So why such a large difference? The managers said that because they carry out their own research, they don’t often look at sell-side models; when they do, it is in situations like this when they try to find out why their outlook is so different from the rest of the market.
They said they have been shocked by what they found, describing: “Forecasts that do not go beyond one or two years, models without working cashflows or balance sheets (who cares about actual cashflows, when you can look at non-GAAP EPS [aka “earnings before bad stuff or inconvenient expenses like actually paying our workers with share options that dilute existing owners”]; models that conveniently back-solve to whatever guidance management has given and abstruse valuation determinants that do not link to business fundamentals.
“The willingness to overlook rational analysis is what allows situations like the recent Gamestop pile-on to happen (still trading at approximately 10x where it was before the Reddit mob descended).
“Why aren’t more sell-side analysts brave enough to call the top? All the time that much-loved stocks continue to defy gravity, all is well; investors are making real money and could sell out if they chose to. Except that greed and fear (of missing out) mean that Mr Graham’s prophetic words will come back to bite you.
“It’s all very depressing.”
Data from FE Analytics shows the BB Healthcare Trust has made 100.93 per cent since launch in December 2016, compared with gains of 66.79 per cent from the MSCI World/Health Care index and 64.32 per cent from the IT Biotechnology & Healthcare sector.
Performance of trust vs sector and index since launch
Source: FE Analytics
The trust is on a premium of 0.98 per cent compared with 0.95 and 1.14 per cent from its one- and three-year averages.
It has ongoing charges of 1.1 per cent.