- The relative valuation of the portfolio is at its most attractive level in the last 20 years.
- We believe a lot of things can still go right for portfolio companies that are rebounding from depressed levels in health care, media and energy.
- The market action in the first half of the year reminds us of the dangers of crowding and suggests we could be in the early stages of a change in market leadership.
We recently spoke with Richie Freeman and Evan Bauman, portfolio managers of the Aggressive Growth Strategy, about trends in the equity market, specific impacts on the portfolio and challenges and opportunities going forward.
How does the current market environment compare with other markets over the history of the Aggressive Growth Strategy?
Richie Freeman: We always try to compare markets but I think the advent of more passive investing has changed things. But today is reminiscent of one market from back in 1973, 1974 when there were a group of companies called the Nifty 50. They sold at about 40 or 50 times earnings and it was thought you just buy those names, you put them away and you never have to worry about them because they continue to compound market returns for years in the future. There was Avon, Polaroid, Xerox, Memorex, names like that. What happened back in '73 and '74, you had such a concentration of money in a number of names at high valuations and they unwound.
We're not calling for an unwinding of some of the great companies right now, but we do see that there has been an incredible amount of concentration within them. And that’s been to the detriment of some of the other names in the market. That has led to the relative valuation of our portfolio being as attractive compared to the market as at any time in the last 20 years (Exhibit 1). We think the portfolio has some downside cushion and based on the values of our companies, we think it remains very attractively priced. This is one of the few times you've seen such a dichotomy in valuation.
Exhibit 1: Aggressive Growth Strategy P/E vs Russell 3000 Growth Index
What are the benefits of approaching growth investing as long-term business owners?
Evan Bauman: We are always looking for great businesses that can grow over decades, not just years, months or quarters. With such a mindset, sometimes short-term performance can be lumpy. But you look at some of the companies that we own today like UnitedHealth Group which will generate about $225 billion in revenue this year. We bought it 25 years ago as a sub billion-dollar revenue company. Some of the bigger biotechnology names we own today, profitable companies with market caps of $50 to $70 billion, were bought as micro-cap or small-cap companies.
We try to identify durable, sustainable franchises that generate a lot of free cash flow that have sustained profitability and in many cases, operate in markets where there's little or no competition. If there is competition, we look for companies with a sustainable competitive advantage whether it's IP (intellectual property) or better products that can stand the test of time. On average, we have owned our top holdings for north of 20 years, which makes us very different.
How does this long-term mentality inform the decisions you are making today?
Evan Bauman: We look for companies that are generally underowned, undervalued or mispriced in the public markets where they can be monetized. Some of the media and health care companies in the portfolio that we have been adding to at extremely low valuations have started to re-rate higher. That’s the goal. It's not to just buy what everybody else is buying, it's trying to buy underappreciated franchises where the market is going to start to figure out what the business should ultimately be valued at or other companies are going to come along and do that through consolidation. We've always said if you buy when nobody owns these equities, there are a lot of things that can go right.
What's happened in energy really from the early part of 2016 on is a good example. Beyond oil prices moving higher, some of these companies were overcapitalized, sitting on tons of cash which they have since announced will be put to work with big buybacks and big dividend increases. And we still think the bull case is not yet priced into valuations.
Richie mentioned the Nifty 50 era. Evan, does this market remind you of any past market environments?
Evan Bauman: You look at history and how our portfolio is trading at about half the multiple of the benchmark and certain areas of the market are very crowded and you have the potential to get into a year 2000 scenario. The NASDAQ 100 was down over 50 percent from peak to trough in 2000 and we delivered positive absolute performance because we avoided the very overvalued parts of the market.
Today valuations are nowhere near as extended as they were in 2000, yet there are clearly parts of the market we find very attractive and other parts we would be avoiding at all costs. The market has been rewarding momentum, it's been rewarding concepts, but it has not necessarily been rewarding franchises and free cash flow. The way 2018 has started out, we think it could be the very early days of some leadership changes, some rotation potential into some of these very uncrowded areas, with M&A being a potential catalyst.
One of the questions we hear a lot is about the benchmark. Is the Russell 3000 Growth Index the proper index to compare yourself against?
Richie Freeman: When they first started establishing benchmarks for this portfolio, I think they compared us to the Value Line Index back in the 1980s. They compared us to the Dow, the S&P. It was really in the late 1990s that we started to be compared against the Russell. I believe it started out as the Russell 3000 Index. We're not going to manage the portfolio depending on what benchmark we're compared to. We are not changing the way we are going to manage the portfolio so there is no reason to change the benchmark to compare ourselves against.
One area though that has seen mixed results is media. What is happening in the media industry right now?
Richie Freeman: You would have thought that these stocks have been massive underperformers this year. The one that really has underperformed and is down this year is Comcast. But away from Comcast, a stealth bull market has been starting. Discovery is in the process, we believe, of being revalued. Companies like Madison Square Garden (MSG) have rallied as it indicates the potential to spin off the Knicks and Rangers into a separate company. The best performing stock in the portfolio this year is World Wrestling Entertainment (WWE). When we bought the shares on a new offering years ago it was thought to be a value stock because it generated good free cash flow. But now that its earnings are being revalued upward, the stock has re-rated higher. So, it doesn't take much to see a reevaluation of a company if you're starting from a great value point.
Evan Bauman: When you think about WWE and MSG and AMC, what they all have in common is unique franchises. We're trying to buy unique, undervalued properties and franchises where there's no equal. And in the case of media, the content is the intellectual property we talk about as making it defensible.
Today, there are a lot of ways to access content. So, whether you access AMC programming over iTunes or Sling or on your phone or iPad, AMC is getting paid because you're accessing their content. And we think that's important. All the attention around Disney and Sky and what's happened with AT&T and Time Warner is validation that everybody wants the same content. We think that wave of consolidation will continue. John Malone has made it very obvious that companies in this ever-changing environment need to gain scale through consolidation (Exhibit 2).
Exhibit 2: Media M&A Activity: Poised for a Breakout?
Do you worry about the rhetoric from the Trump administration regarding creating a more level playing field for drug pricing?
Richie Freeman: I always worry when the government starts talking about an area that we have big investments in. I've been worried about pricing since going back to the 1990s. Unless companies are asked to voluntarily roll back prices or there are mandatory roll backs, we think it's something which caps multiples somewhat. Longer term, we don't think it's going to affect the businesses.
What's most important to us is what the companies have in the pipeline. If we own companies that weren’t developing new drugs, they were just living off price increases, continuing price increases to grow sales and earnings, I think that's a dangerous investment. But if you have a company that has drugs in their pipeline that could be revolutionary and address unmet medical needs, we think that is by far the most important thing you can have as an investment.
Biogen is very important. The multiple sclerosis market obviously is very important with Biogen. We don't think they're going to be getting anywhere near the pricing flexibility in the future that they have enjoyed in the past. But what's most important is what's in the product pipeline, will Alzheimer's be a major driver of sales and earnings in the 2020 period, will ALS be a market that they could address?
That’s why you own these companies. You don't own them just for the present, you own them for a combination of cash flow from the present and exciting product pipelines for the future.
In terms of Amgen, I’ve referred to that company consistently since the 1990s as a bank that happens to sell drugs. If you look at their financial statements, they generate enormous cash flow which they have prudently been reinvesting in the business. They spend a lot of money on R&D, as well as paying a meaningful dividend, and buying back stock. This is a company which made some very smart acquisitions over the years. We thought it was expensive when they bought Immunex back in 2002 but with the revenue generated by arthritis treatment Enbrel, it turned out to be a very prudent acquisition. Most recently, we think the early reading on their migraine drug has been successful. Amgen is a name we've owned since the 1980s and is still a top holding.
Evan Bauman: Just to give you an example of how accretive tax reform was to some of these companies, Amgen had $40 of their $42 billion in cash overseas which essentially couldn’t be touched. It's now back and is being used in very accretive ways through buybacks and potentially for innovative acquisitions.
It's just amazing how the big biotechnology stocks are the polar opposite sentiment-wise to big tech, where there's enormous complacency and ownership. Biogen was up 20 percent recently on an early stage piece of data for Alzheimer's because investors have gotten so negative about everything.
You are assuming almost no pipeline contribution for some of these companies which is simply not going to be the case. We are seeing game changing type science in therapy and gene editing and what Vertex has done in treating unmet need with cystic fibrosis.
Technology has been the driver of returns in the market for the last two years. What are your thoughts on technology, which is a big weighting in the overall portfolio.
Evan Bauman: Not only is technology a big portion of the strategy, it's been one of our best performers and we’re not sure that's well understood. Our very minimal exposure to the FAANG names (the portfolio has a small position in Facebook) has masked some of the positive stock selection in the sector.
Year to date, just to give you some examples, Seagate Technology, a disk drive maker, Twitter and software companies Autodesk and Citrix are all up substantially. Cree is a company which has really refocused its business on silicon carbide and gallium nitride chips, which are sold into electric vehicles, and has rallied significantly off its lows.
We own a lot of suppliers and the enabling technologies for some of the big companies, the big device makers and consumer companies, we just don't own the consumer device companies themselves. Broadcom is a big supplier of high-end chips to Apple. In technology, we try to identify businesses and franchises that have sustainability and pricing power as opposed to consumer tech. Those consumer end markets are extremely cyclical from a market share and a mind share perspective.
With Broadcom, when their CEO Hock Tan describes what he looks for, it's very similar to what we do. It's about companies and assets, franchises that generate sustainable free cash flow that have dominant market positions in areas where there's not a lot of competition and high recurring revenues.