Investment Activity Review - November 2014

After the brief “correction” in October, the market basically pulled a Men In Black where it essentially looked at the pen and proceeded to forget the past and resumed its ascendency to record highs. I made a couple of moves on my portfolios to bank some profits and to open some new positions. This is despite my feelings that the stock market is still overpriced.

Sold position in Target Inc (Ticker: TGT) for 20.1% gain

I bought some Target stock originally because I felt it was oversold as a result of a perfect storm of negative events that hit the company, specifically the disappointing expansion into the Canadian market as well as the huge credit card breach which scared customers away.  Since that perfect storm which culminated in firing of the CEO of the parent and the President of the Canadian division, the company has been making positive inroads. Customers began to shake off the security concerns and returned to the stores, which has historically been the norm for companies suffering a credit card security breach. The new management team also made strong commitments to address the supply chain/inventory issues which were plaguing the Canadian stores. It’s not going to be fixed overnight and they realize it.

I bought the stock at about $56. The stock had popped quite meaningfully in the last month and in November the stock crossed my personal threshold return that I am always seeking on all my investments which is 20 percent.  I still like the company and am confident that the new leadership will take the appropriate steps to turn around the business, especially their Canadian operations. They seem to understand the value and cachet of the Target brand and it looks like there will be a greater vigour to preserving and revitalizing the Target brand.  At that point, I felt that I was satisfied with the return to date and decided to bank the profit. I think another factor that was in my mind was my belief that a major stock market correction is coming (no idea when) and that I feel more comfortable banking profits now.

Subsequent to my selling of the stock, the company reported better than expected earnings along with improved results from the Canadian operations  (they still lost money but it was less than in previous quarters). I sold the stock at $66 but the stock kept rising and is now in the $71-72 range.  Even though I left money on the table, I’m still OK with it because I being consistent with my strategy and my confidence that other opportunities to buy great companies will present itself.  In hindsight, maybe I should have waited until the earnings report came out. At the same time, if the report was lousy, then stock would have fallen. If it did I would have likely bought more stock if management was demonstrating their commitment to address the operational issues of the company. What’s key is either way, I had a plan for the stock.

If the stock should fall back meaningfully in a market correction and the fundamentals of the business are intact, I wouldn’t hesitate going back in. I personally find it more palatable from my personal risk tolerance profile, to generate long term returns in chunks  by rotating in and out of a company stock. In other words buy the stock, hold it until it reaches my desired return and sell and then buy again on a meaningful price drop if the there is no change in the performance of the business. Instead hitting a home run on a stock, if I can get chunks of returns iteratively over a longer time frame, then I am still generating better returns while controlling my risk exposure. It’s a strategy I’ve been using as I’ve built up my personal investing experience.

Sold Visa (Ticker: V) for 24.6% gain

I originally bought into Visa at $201. The stock had been trading in a range of $210-220 until a few weeks ago when the stock popped to near $250 on a positive earnings report specifically:

  • Net operating revenue of $3.2 billion, an increase of 10% on a constant dollar basis over the prior year.
  • Payments volume growth advanced 12% over the year-ago quarter, while total processed transactions increased by 9%.
  • The company recorded adjusted quarterly net income of $1.4 billion or $2.18 per diluted common share, an increase of 14% and 17% over last year’s quarter, respectively.

The company continues to essentially print money at will. The balance sheet is rock solid with very little debt. That’s right. A financial company with no debt.  A rare sight indeed. So why did I sell? When it got to $250 I was up about 25 percent which again was above my personal return threshold of 20 percent.  I don’t see anything fundamentally wrong with the company. It appears to be meeting the future challenge of online payment systems head on and has jumped aboard the Apple Pay system. No matter what electronic payment system emerges, Visa will get a cut from it. I personally thought the stock had run up pretty fast and so I thought it could be ripe to pull back. I thought I’d rather lock in a 25 percent gain and if it did pull back that I would buy it on any correction. Again playing the same building return in chunks approach.

Added to position in Gilead Sciences (Ticker: GILD)

I thought a good way to share how I go about making investment decisions is to work off a posting I wrote a few months ago called 8 Questions To Ask When Evaluating A Stock. Below are my responses to the questions as it related to my decision to buy Gilead Sciences. As you can see, you do not have to answer all of these questions in great depth or write a pHD thesis defence. The reality is I’m not a Doctor nor do I play one on TV so my answers and analysis will be very basic and short. For those who work in the pharma industry, their knowledge will allow to them to do a deeper dive.

When I speak with people, the overwhelming number one turnoff they have about investing is math and fear of having to do a lot of it.

One of the great myths I’ve learned about investing over the past 18 years is that you DO NOT have to spend hours upon hours pouring over reports and crunching numbers to evaluate a stock. This is true if you are a financial analyst but if you are just making investment decisions for your RRSP, you don’t need to go into analysis paralysis. You just need to ask some simple fundamental questions and leverage some key financial indicators, which are amply available publicly.

QUESTION 1: What do they sell?

(I found this at Seeking Alpha) Gilead Sciences, Inc. is a global biopharmaceutical company, founded in 1987, that develops and distributes medicines to treat life-threatening diseases. The company has a portfolio of 21 approved drugs that treat HIV/AIDS, liver disease, tumors, cardiovascular disease, influenza, cystic fibrosis, fungal infections and macular degeneration.

In their portfolio they have a couple of drugs that are highly popular. One is Sovaldi which is used to treat Hepetitis C and a new drug they recently obtained approval which is Harvoni. These two drugs on their own generated $3.2 billion in sales in their last quarter (about ½ the companies revenues). In total they sell about 24 different kinds of drugs.

QUESTION 2: Who do they compete with?

GILD competes with other major pharmaceutical companies like Pfizer, GlaxcoSmithKline, Bristol  and Myers Squib.

QUESTION 3: Who buys their products and services?

From what I’ve read, Gilead has positioned themselves as the leaders in drugs that cater to patients with respiratory issues as well as patients suffering from Hepititis, HIV/AIDS

QUESTION 4: Will people buy it over and over again?

Treatment for these ailments requires a constant and sometimes intensive program of medicines and drugs. The drugs that Gilead sells are not a one dose and you’re done solution.

QUESTION 5: Do they make money?

We know what Gilead does and so far it looks interesting, but at the end of the day, it’s about profit and wealth creation. Does Gilead actually make tangible money from their business? The time has come to review some numbers. The primary source would be the company’s financial statements, specifically their Income Statement. You can go there but also there are wealth of resources that have crunched the numbers for you.

(Again pulled this from Seeking Alpha) For its third quarter ended September 30, 2014, Gilead Sciences had total revenues of $6.04 billion (up 171% over the year-ago quarter), income from operations of $3.48 billion (up 203%) and net income of $2.73 billion (up 246%), or $1.67 per diluted share (up 255%). Pretty impressive stuff.

Revenues were led by 138% increase in anti-viral product sales and an 11% increase in cardiovascular product sales. Sovaldi, which the company launched in December 2013, was the company's top performing drug, and accounted for approximately 47% of the company's total product sales of $5.97 billion.

The company over the past two years has generated return on invested capital of beteween 23 and 32% vs a cost of capital of about 11%. Based on this the company is creating tangible wealth or Economic Profit for its shareholders.

You could drill down further into their various business segments if you have the time, but it really isn’t necessary. So to answer the question, Gilead seems to be making a lot of money right now. If they didn’t, our analysis would stop right here. We move on.

QUESTION 6: What do they own and who do they own money to?

This question can be answered by looking again to the company’s financial statements, specifically its Balance Sheet and reviewing the quality of their assets and how they raised the capital needed to run the business.

As of September 30, 2014, Gilead Sciences had $7.69 billion in cash and cash equivalents, $28.84 billion in total assets, $8.93 billion in long-term liabilities and $13.86 billion in total stockholders' equity. During the third quarter, the company generated $4.04 billion in operating cash flow.

Notably, the company paid-off $7.93 billion in outstanding long-term debt at the beginning of the quarter and is now debt free. In other words the company is financing its operations from the profits it generates organically within the business. This is a very good thing.

 QUESTION 7: How risky is their business?

Pharmaceutical companies are risky companies to invest in because of two factors; Limited patent exclusivity and high capital costs for research and development. Because drugs have a limited patent life, once they expire, other competitors can come in sell the same drug at a much lower price which will dent the developing company’s profits. In addition, developing safe and effective drugs doesn’t happen overnight. It takes years and decades to develop and also to obtain regulatory approval to market them, so companies will spend ridiculous amount of R&D money that could yield 1 marketable product. The key though is once you obtain approval and it is a popular drug, the financial rewards are overwhelming. Because of these factors, pharma company stocks are very risky and can suffer violent price swings. It is truly high risk high reward proposition with these type of companies.

There has been great debate on the high price of Gilead’s drugs and the moral responsibilities the company and other pharma companies have to operate within. Harvoni will be priced at $95,000 for a 12-week treatment course, more expensive than the $84,000 price for a 12-week supply of Sovaldi (for the treatment of Genotype-1 Hepatitis C) because Harvoni can be used standalone, without additional medications and has been shown to successfully treat patients within the 12-week treatment course at lower total cost. A risk is that the company can come under government pressure to make their drugs more affordable which could impact their profits.

QUESTION 8: Is the stock cheap?

(From Seeking Alpha) At $100.44, Gilead shares trade at about 18x earnings, 11x book value and 15x cash flow, with a market capitalization of $151.5 billion on 1.5 billion shares outstanding, and near the high end of their 52-week range of $63.50 - $116.83. Price-to-Earnings valuation is significantly below industry peer average of 29.8x and lags Gilead's long-term growth rate of 24%. On a discounted cash flow basis (source Valuentum), the stock is valued in the $150 range, so the stock despite its strong financial performance  is still trading at a healthy discount.    

Conclusion.

Based on these responses, I decided to buy Gilead because it met most if not all of my criteria for a good stock that can increase in price in the future, specifically:

  • Gilead is market leader selling products that are highly in demand (Dominate the Hepatitis market).
  • They have sound, competent management that can execute their strategy
  • Their products generate consistent tangible wealth and Economic Profit for their shareholders (Returns on Capital > Cost of Capital)
  • They have a clean, solid balance sheet (Manageable debt, little Goodwill)
  • Their stock is selling at a discount (Gilead trades at $100, while their valuation is coming in the $140-150 range).

During the month, the stock pulled back from the $110 range down to high $90’s. There wasn’t anything negative out there that warranted the price drop so I decided to add to our position to lower our cost base for the stock.

Opened position in Blackberry (Ticker: BB)

One of the core mantras of investing is to buy low and to sell high. For the average investor, the best time to buy low is unfortunately at times where a company is not doing very well or if other investors and analysts become downright negative on a company’s future prospects.   Negative sentiment breeds lower stock prices.  Most times the negative sentiment is correct, however there are many opportunities where the sentiment can be wrong and if you can identify those companies whose stock appears to be mispriced by the market but are still creating tangible wealth and be patient enough to ride it, you have a pretty good chance of making some money in the long term as eventually the market will recognize and price the stock accordingly.

One of the most hated and despised stocks the past few years has been Blackberry (formerly Research In Motion).  They pretty much owned the smartphone/email messaging market until the Apple iPhone and subsequently Android came along. Hubris got the best of the management team who thought they were invincible and could not respond to the new players.  The stock went from the mid $200’s to almost a couple of bucks in less than two years.  Many investors including myself had them heading for bankruptcy or some kind of liquidation of their technology and patent portfolio.

Using the 8 Questions process I used for Gilead would be hard for a company like Blackberry because if you look at them at face value, the prospects are daunting. They are now essentially not even on the radar screen when it comes to smartphones. Their revenues and profits have been steadily falling. Many major clients have switched to other smartphones fearing the company will go bankrupt.

So why did I buy a stock that really doesn’t have anything going for it and could essentially fall to $0?

The simple answer is that Blackberry is transitioning to become a totally different company with a totally different business and more specialized business model.  Because of this, trying to evaluate and compare the performance of Blackberry 2.0 with Blackberry 1.0 based on numbers is comparing apples and oranges.  It really comes down to evaluating what the company’s strategy is going forward.

Again trying to keep things simple.  The new leadership is essentially trying to return the company to its former roots and to re-position the company based on its strong core competencies.  Blackberry’s bread and butter has always been creating technology that caters to elevating the communications of the corporate or enterprise market.  The products and tools they designed were extremely beneficial to businesses especially financial companies and Government. Real-time push email that was extremely secure was their competitive advantage and they built a legion of followers/addicts who truly couldn’t live without it.  They were very good at executing to serve these segments. Then along the way, the founders of the company thought they could translate this same strategy to the consumer market even though they had zero experience selling to retail consumers. They did make some headway but then iPhone came and totally changed the game. Apple’s core competency was designing products for consumers and they do it very well. Blackberry at first scoffed at the entry of Apple but then quickly realized they were going to be a force and essentially went all-in on rushing products that were poorly designed, lacked integration or functionality and essentially ignoring their core enterprise customers. They failed miserably.  They lost focus and they couldn’t react in time. Then Android came in and right away further cut deep into Blackberry’s market share. They were in trouble. To preserve cash, significant jobs were cut. It looked like bankruptcy was in their future.

After a failed attempt to sell itself off, the leadership decided to try and right the ship on its own. It brought in John Chen an executive who had a bit of track record turning around technology companies, notably Sybase. Mr. Chen came and took stock of the company. He realized two things. 1) They needed to get out of the phone making and manufacturing business and focus on the software. 2) They needed to focus on what they do well and that is designing solutions for enterprise customers.  Chen has pounded the pavement trying to convince anyone both in the company and outside that Blackberry could still offer value and be a force in the mobile market, but instead of selling the face of a smartphone, Blackberry would sell the plumbing of what makes mobile networks function. He decided that the company would get out of the manufacturing of hardware and instead outsource that function.

Backers led by some powerful investors including Prem Watsa of Fairfax Financial who has excelled in the past of taking stakes in turnaround companies (Mega Bloks is one example). Watsa took a huge stake in the company only to sell it, because of perceived conflict of interest. He’s been on record saying he thinks Blackberry will be successful in its new model.

Just recently Mr. Chen laid out a formal strategy for the company, which emphasized a greater focus on targeting the enterprise market. What was notable was that he announced it is partnering with Samsung Electronics Co. to bring its security standards to the handset maker’s smartphones. Samsung is the dominant brand in the Android ecosystem and up until now a direct competitor to Blackberry. The partnership is significant in that for the first time Blackberry is willing to open up their technology to other platforms. If you want to really speculate, you could say that this hook-up is the first step in potential long term relationship where Samsung would ultimately scoop up Blackberry. It’s a stretch but stranger things have happened.

At the end I decided to buy a very small position in Blackberry mainly as a speculative position. My motivation is based on a belief that the company is much more focused now on leveraging its core competencies and is now embarking on executing a strategy to transform itself into an enterprise software services company from a hardware company. They have a management team that has track record in successfully executing turnarounds. I have no idea if they will be successful, but compared to a year ago, I think they have a better and average fighters chance of pulling it off. At the very worst, the company is still an asset play and could be worthy of a cheap takeover by a Google, Microsoft or Apple. I really did not crunch much numbers on this because previous metrics were under a very different company that it is now. I am definitely going away from the playbook on this one and it can very much blow up in my face. My decision is driven primarily on their strategy.