Pictured: The long-term view of Gilead’s Harvoni franchise has blurred. Prices updated, as of 1:36pmCT.
By Brian Nelson, CFA
We were very pleased by the market action of Friday, January 29, with the top weightings in each of the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio performing extremely well.
Visa (V), the largest weighting in the Best Ideas Newsletter portfolio (7%+), is simply “on fire,” with the company trading ~5% higher on the session at the time of this writing. The high end of our fair value range of $90 per share for shares is starting to look within reach for the credit-card network, “.” Visa generates an operating margin in the mid-60% range (not a typo), and there are very few companies that come anywhere near that mark. The company is expecting “high-single-digit to low double-digit” annual net revenue growth on a constant dollar basis for fiscal 2016, and we maintain that the runway of growth is a long one for Visa as the ongoing transition to a cashless society ensues. This pace of top-line growth at these “astronomical” levels of profitability translates into significantly high levels of economic returns (profit), meaning that the firm’s very attractive Economic Castle rating, “What Is An Economic Castle,” is as strong as ever. Annual free cash flow at Visa is targeted at ~$7 billion for the fiscal year, and there may be upside yet from its Visa Europe transaction. The run in Visa’s shares is not over, in our view, and we expect an upward bump to our fair value estimate upon next update.
Microsoft’s (MSFT) shares, one of the highest-weighted equities in the Dividend Growth Newsletter portfolio (5%+), is also powering ~5% higher at this print, “Microsoft!” Why might we let a fairly-valued equity “run?” For starters, the forward-looking nature of valuation necessitates a margin of safety around any point fair value estimate, and the fair value range of Microsoft’s shares ($44-$66) acts as not only a safety-net to assessing the downside risk but also the equity’s upside potential. The fundamental margin of safety is outlined in many historical texts, including those of Benjamin Graham and Warren Buffett, and the Valuentum process fully embraces this theoretical concept with open arms. We also, however, acknowledge the important information held within prices, and we may let equities run past their fair value estimates to the high end of the fair value range with the notion that even an optimistic view embedded in a fair value estimate could still be too conservative. We’d only sour on newsletter holdings when they surpass the high end of the fair value range and when their technicals have rolled over considerably. We also tend to be more lenient with hefty and solid dividend-payers, particularly those held in the Dividend Growth Newsletter portfolio (as in Microsoft’s case), as identifying high-VBI rated and lofty dividend payers can at times be a tough foot to bill to gain “proper” exposures.
On the other hand, for companies where the fair value estimate range may be large, as in the case of Gilead (GILD), meaning the uncertainty regarding the magnitude and duration of future free cash flow is rather wide, we may put incrementally more emphasis on technical and other indicators than the long-duration, free-cash-flow-based fair value estimate, which may be fraught with “higher-than-normal” forecasting risk, which occurs with a higher incidence rate in the biotech space relative to other industries. In these instances, we may remove companies that we still believe are undervalued on the basis of our discounted cash-flow process, if other critical indicators are pointing to significant “tough-sledding” in the near term. In the latest edition of Valuentum’s “Financial Statement Seminar,” we talked about the sensitivity of a fair value estimate, for example, to changes in mid-cycle operating-margin forecasts in the context of Amazon (AMZN) and Microsoft. Where a one-percentage point change in a mid-cycle operating margin assumption for Amazon, for example, resulted in a $60 per-share fair value estimate change, that same adjustment only resulted in but a “few-dollar” fair value change for the software giant. In such cases, we’d have significantly greater conviction in our valuation of Microsoft than we would in the case of Amazon, which incidentally is trading off nearly 8% on the session January 29, while Microsoft and the broader market move higher.
During the past few weeks, there have been a number of developments that have raised concerns with respect to the Best Ideas Newsletter portfolio’s position in Gilead Sciences. The biotech (IBB) industry has been performing horribly as of late whether from “political” badgering or from capital-flight to safer assets, and from my “buy-side” days, an individual equity’s total stock return can be broken down, generally, as follows: 40% industry return, 30% market return and 30% individual return, give or take. The first two dynamics (industry and market) have contributed poorly to overall performance at Gilead, and in this context, the FDA approval of Merck’s (MRK) once-daily single-tablet combination therapy, Zepatier, a significantly less expensive alternative (read: “pricing war”) to that of Gilead’s prized hepatitis-C drug franchise has become enough for us to say good-bye to Gilead, if only for now, and even as we say shares may still be cheap.
Quite simply, as in the case of Alibaba (BABA), we don’t want to take part in what could be a deepening slide in shares to come, and from our perspective, the risk that the firm may turn into a “value-trap” has increased materially in light of such recent developments. Pricing is a “huge’ lever in the model, and if Gilead has to engage in even a nominal price reduction to retain share, the implications on value are rather large, not to mention that the cash-flow duration of its future free cash flows related to hepatitis-C may become truncated with the entrance of another FDA-approved drug. Having said all of this, we’re removing our entire equity position in Gilead in the Best Ideas Newsletter portfolio at $83.37 per share, and replacing it with a 3% weighting in Johnson & Johnson (JNJ) — $104.18 — “Johnson & Johnson Reports Strong Underlying Performance,” “Giddy Up – It’s Earnings Season.” Exposure to Gilead, however, is retained via the newsletter portfolio holding’s weighting in the Health Care Select Sector SPDR (XLV).
The Best Ideas Newsletter has benefited considerably from the addition of eBay/PayPal under $30 per share in October 2011, “The Transaction Log of the Best Ideas Newsletter Portfolio,” and with the one-for-one stock distribution following the split, the combined value of the equity position, or the sum of the per-share values of eBay (EBAY) and PayPal (PYPL) is now $58 in aggregate — $23 for the former and $35 for the latter, implying a double since the time it was added to the portfolio. We think the time is ripe to part with the former, eBay, in the Best Ideas Newsletter portfolio (now a very small weighting), and we’re removing shares at $23.15 each. Though shares of eBay may bounce back a bit following its disappointing results, we’re ready to add Facebook (FB) to the Best Ideas Newsletter in its stead, “The Bounce in Energy and Potash’s ‘Surprising’ Dividend Cut.” Facebook’s cash-rich, debt-free balance sheet and its tremendous pace of free cash flow generation is simply hard not to like. We’re now pointing to the high end of the fair value range as a likely scenario for shares even in the face of a weak broader market environment, “.” We’ll be establishing a 3% position in Facebook — $112.10 — in the Best Ideas Newsletter portfolio, and we would expect an upward bias to our estimate of its intrinsic value upon the next update.
The average holding period for eBay (~61 months) and Gilead (~16 months) was ~33 months. We’re available for any questions.