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By Brian Nelson, CFA
Our trade(s) in the Best Ideas Newsletter portfolio with respect to hepatitis-C juggernaut Gilead (GILD) is (are) not something I’m proud of. I know the Best Ideas Newsletter is performing fantastically, and we continue to outdistance the broad market benchmark, but I’m not satisfied unless I get everything right, even though this is an unattainable goal.
Here’s what happened. I was enamored by Gilead. The pharma giant had found a cure for hep-C. It was a free-cash-flow generating behemoth, and its balance sheet was solid. What I did not anticipate was just how easily its patent on Harvoni/Sovaldi could be circumvented and how the economics would be truncated, both with respect to volume and price. In many ways, Merck’s (MRK) entrance into the hep-C market with its own arguably equally efficacious cure, in the form of Zepatier, caught me completely off guard. So much for economic moats, eh?
Still, I had been confident in my call on Gilead. After all, the market had been rewarding many in the biotech space for much of this bull market, and absent the fallout with Valeant (VRX) and political pressures to lower the price of high-profile drugs, the backdrop had still been a rather good one. The Best Ideas Newsletter portfolio, even though it contained some pharma/biotech exposure in the Health Care Select Sector SPDR (XLV) and Teva Pharma (TEVA), was lacking a beta-driven play with speculative upside. Gilead seemed to fit the bill nicely, in my opinion, and downside seemed rather limited in light of its single digit P/E ratio.
I was wrong. We added Gilead to the Best Ideas Newsletter portfolio in the range $100-$110 per share on two separate occasions in late 2014, and I ended up throwing in the towel January 2016. The price at which Gilead was removed was $83.37 per share, and it had been a ~3% weighting, costing our outperformance 60 basis points or so. It may have been one of the biggest errors that I’ve made in managing the Best Ideas Newsletter portfolio since inception. But let’s look at this a little closer.
The share price of Gilead has continued to fall since we removed it from the Best Ideas Newsletter portfolio, now trading at ~$73, and Johnson & Johnson (JNJ), the dividend stalwart that replaced Gilead in the Best Ideas Newsletter portfolio in January, has performed quite well. The decision to remove Gilead prevented absorbing a further 10%+ drop, while J&J has advanced to nearly $120 per share from under $105, a near 15% leap, excluding dividends received. Had we just held onto Gilead and not added J&J, things would have been much worse.
In many ways, the move to remove Gilead and add J&J in its place has made the “Gilead trade” a wash. Said differently, one of the biggest errors that I’ve made in managing the Best Ideas Newsletter portfolio during the past 5+ years has been roughly net-neutral on performance. I feel blessed with some degree of luck, of course, but I also have to tell you that our team is working incredibly hard. But why am I writing this article–to pour salt in my own self-inflicted wounds? No, of course not. Here’s why.
First, the market today is not an easy one. We’re in defensive mode, and we continue to point to ideas in the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio as our favorites to consider.
Second, the P/E ratio can be misleading more often than not. That’s why we always use the P/E ratio in conjunction with a robust, forward-looking discounted cash flow (DCF) process. Unfortunately, in the case of Gilead, Merck’s Zepatier has added significant risk to our published fair value estimate.
Third, please keep things in perspective. The weightings we assign to each stock in the newsletter portfolios offer insight into our level of conviction in each idea. At its biggest weighting, Gilead stood at just 3% of the Best Ideas Newsletter portfolio. The weightings that we assign to each stock in the newsletter portfolios are just as important, if not more so, than the stocks themselves.
Fourth, in many cases, the reasons why we add or remove a company sometimes have more to do with achieving newsletter return goals than with the company, itself. For example, in Gilead’s case, we added it in part to add a degree of speculative upside in a sector that we thought was underweight within the Best Ideas Newsletter portfolio construct.
Fifth, if you are familiar with our trade on Gilead, you may think that we simply have no idea what we’re doing–adding a company and then removing it just a short year later at a loss. But, as this note outlines, the net impact of the moves related to Gilead offered readers a net-neutral proposition, as one of our biggest errors of the Best Ideas Newsletter portfolio since inception.
Frankly, a net-neutral proposition as one of our WORST trades isn’t bad. I believe not losing money is one of the primary reasons the Best Ideas Newsletter portfolio has exceeded the S&P 500 market benchmark since inception, while more than 90% other big cap funds have trailed. We never take our eye off of Warren Buffett’s two main rules: Rule No. 1: Never Lose Money. Rule No. 2: Never Forget Rule No. 1. [As a side note, Buffett is losing billions in Wells Fargo (WFC) as of late!]
Please work to gain perspective! Seek to understand context! Trust me–In doing so, you’ll become a great portfolio manager, if you’re not already. Cheers!