We continue to believe that the pharmaceutical industry is selling at an undervalued price. In the semi-annual report, we detailed why we thought it was cheap. We wrote the following:
“As if Valeant (NYSE:VRX) has not given enough pain and anguish to our unitholders, we believepharmaceutical stocks as a group are selling at attractive valuations. They generate their earnings in cash and most of them are selling at less than 10 times cash earnings. Some of them are down more than 50% from their highs, which is what caught our attention initially. It may look like we are adding more emotional fuel to the fire from our experience with Valeant but we look at mispriced stocks on a case-by-case basis. Given our current favorable view of the pharmaceutical industry generally, as next discussed in greater detail, we expect to invest in stocks of more than two or more pharmaceutical companies (that is, to utilize a so-called “basket approach”), in order to reduce the potential adverse effect on fund returns that could result from Food and Drug Administration (FDA) approval and patent expiration issues faced by a single company.
A Historical Perspective
What the pharmaceutical industry has been going through lately reminds me of what happened in the U.S. in 1994. A year earlier, then-president Bill Clinton appointed his wife, Hillary, to head a committee to prepare legislation for overhauling the U.S. health-care system, sending ripples of fear among investors of pharmaceutical stocks. It appeared as if drug prices would be set by the government on the basis of what it would cost to manufacture the product rather than being set by the market. Almost all pharmaceuticals stocks dived for the next of couple of years to unreasonable bargain levels.”
Investors were particularly nervous between Clinton’s victory in November 1992 and throughout Clinton’s health-care reform proposal from 1993 to 1994 (see Figure 1).
“The health-care reform package was eventually defeated in August 1994, sending an air ofrelief to the pharmaceutical stocks. They returned to their more fairly valued levels set from 1994 to 1998 (see Figure 2). The Republican revolution led by Newt Gingrich gave Republicans control of the Senate and House of Representatives, putting the final nail in the coffin for a health-care overhaul under the Clinton administration.
”‹Below are the graphs that compare the prices of three pharmaceutical stock prices both before and after August 1994.
In conclusion, we believe pharmaceutical stocks as a group are selling at attractive valuations, in comparison to the free cash flow and earnings they generate. The recent price drops may present one or more attractive long-term investment opportunities for us.”
However, in the beginning of the fourth quarter, due to the amount of U.S. bank warrants and stocks that we sold, we had realized capital gains of close to $18.14 per unit. If we were to pass down the capital gains to our unitholders, it would leave a large tax burden to them during the income tax season. This tax burden would be easier to bear for our unitholders if we had outstanding returns for the last few years. However, the reality is that we did not have the best of years. In order to mitigate the problem or eliminate it, we sold all the pharmaceutical stocks in which we had unrealized losses, hoping to buy them back a month later (31 days) at close to the same price we sold them. Sometimes, there are other stocks in the same industry that are equally cheap and we would buy them as a hedge in case the stocks we sold ran up in price. That is why we added DaVita Inc. to our portfolio at about $54 per share. Unfortunately, since timing was not our greatest strength, the pharmaceutical stocks took off in December and we did not get the full benefit of their rise. Luckily, we had DaVita Inc. in our portfolio, which increased 33% to $72.25 at year-end 2017, softening some of the blow from the rise in the other pharmaceutical stocks.
In the first quarter of 2018, we have bought back some of our holdings in Valeant Pharmaceuticals and Endo International when they came down in price.
From Francis Chou (Trades, Portfolio)'s 2017 Chou Associates Fund shareholder letter.
