The drum beat of negative news grew louder through the third quarter, but this did not deter US equity markets. The major indexes slowly pushed higher through the quarter and continued to do so through late October.
The items on my worry list have not changed since the Q2 letter and continue to push my hairline further back and shift my hair color more towards salt vs. salt and pepper. The one change since last quarter has been the manifestation of these concerns in the Q3 earnings results. The current state of business and the forecast for the coming year is not as bright as it was 90 days ago. There is incremental concern about the future mostly driven by the still unresolved U.S. / China trade agreement. The U.S Federal Reserve Bank has recognized this and continues its path of interest rate cuts in order to stave off any large-scale economic slowdown.
At Carmel Capital our mandate is to protect and grow client’s investment capital – in the that order. In a perfect world we’d like to be 100% invested all the time, however, very rarely do we achieve this state of investment nirvana. Most of the time it’s a continuous assessment of risk vs. return and choosing where we can allocate capital to generate investment outcomes that are satisfactory and able to meet client’s goals. We believe this prudent and deliberate approach is sensible over the long-term, however in the short-term (especially in year 10 of a bull market) it will appear inferior to the index/ETF based “fire and forget” approach that inhabits much of todays investment landscape. We believe a more thoughtful approach of allocating capital to public and private equity, fixed income, and real estate, will allow us to fulfill the mandate stated in the first sentence of this paragraph.
Why mention the above? In the current environment of new market highs, the idea of not being all in on equities appears foolish. However, we prefer a combination of public and private investments, to deliver results. This becomes especially relevant in an environment where political and economic news continues to get worse, not better. Our preference is to a have a diversified and durable investment portfolio that we believe can sustain itself through just about any market environment.
We continue to invest for the long-term but are prepared to navigate any short-term turbulence that may materialize.
Our equity returns though Q3 2019 (excluding cash) on average increased 14.9%, and on average our equity accounts increased by 12.2%.
During the quarter we initiated new positions in Bristol Meyers (BMY) and IQVIA Holdings (IQV)
IQVIA (IQV) / Market Cap: $28 billion
IQV designs and runs clinical trials as an outsourced service for biotech and pharmaceutical companies; and collects and sells data and analytics subscription software platforms to the broader life sciences industry. The company was formed in 2016 upon the merger of two existing publicly-traded companies – Quintiles, the leading provider of outsourced clinical trial services; and IMS Health, the leading provider of healthcare industry data and related IT services.
Bringing IMS’s gold-standard healthcare industry data and analytics in-house allowed for improved clinical trial services and differentiated service offerings relative to its competitors. Specifically, data and analytics were used to improve clinical trial design, to speed site and patient recruitment, reduce adverse events and reduce costs for its customers. Reducing clinical trial time while simultaneously achieving more consistent execution and better controlled trials can result in new drugs getting to market faster. Now three years into the combination, the merger has been an obvious success with IQV’s clinical services showing faster growth than its competitors, with expanding margins.
Meanwhile, IQV’s information services business is far ahead of the industry in data collection having more than one million data feed sources, two trillion transactions captured annually on a global basis and hundreds of patents for proprietary data extraction methods. The company also has spent in excess of $1 billion in recent years to develop an Artificial Intelligence platform on top of its data warehouse. This initiative employs more than 2,500 data scientists and has progressed to the point to where only 20% of resources are spent on scrubbing data versus a more typical 80% in earlier stage development. AI-driven solutions can eliminate manual processes and various technology silos, leading to cost-savings for customers, improved execution for providers and better outcomes for patients. With industry adoption of AI still at an early stage, these services will become increasingly valuable over time.
Bristol-Myers Squibb (BMY) / Market Cap: $89 billion
BMY’s pending acquisition of Celgene will bring its combined annual worldwide sales to nearly $40 billion, on par with or near the current top 5 drug companies. Both companies have leading drugs for cancer treatment (Opdivo and Revlimid, respectively), which among other existing and pipeline drugs will give BMY the leading oncology franchise in the industry. Other key therapeutic areas include cardiovascular and arthritis.
Management expects the merger to achieve meaningful cost efficiencies in R&D, synergies in sales/marketing, improved risk diversification and a more consistent growth profile given the growth vs. decline cycles around regulatory approvals and patent expirations. The acquisition was initially met with skepticism due to increased debt required to complete the deal and scheduled patent expirations within several years for Celgene’s leading drug, Revlimid. The price decline following the acquisition announcement led to a highly attractive entry point for BMY with the stock selling at 10x earnings with a 4% dividend yield – a very large discount to its major pharma peers – despite an apparently accretive acquisition and a more robust future drug pipeline.
A critical question is the patent expiration timeline and subsequent revenue decline of Revlimid, which accounts for 60% of Celgene’s current sales and about 25% of pro forma BMY sales. Celgene management has been highly successful at extending Revlimed’s cash flow accretion through reformulations, dosage adjustments and various legal challenges. Accordingly, we believe Celgene on a standalone basis could continue to grow overall revenue through 2022, and the ultimate decline thereafter can be mitigated with a combination of currently marketed drugs and promised late-stage pipeline drugs. On a post-merger basis, revenues can grow at a 5% compound rate through the initial Revlimid decline year in 2023 with EPS compounding in excess of 10% as a result of cost synergies and share buybacks. We expect dividends to grow in-line with EPS and debt to be substantially reduced from a day one $42 billion to below $20 billion by the end of 2023. The merger is expected to close in late Q4 this year or early 2020.
During Q2 we sold ADS, SAVE and CFRUY.
Fixed Income Update
Not much has changed across the fixed income landscape since the Q2 2019 letter was written. The investment environment remains tough, with interest rates at historically low levels and ability to generate attractive returns challenging.
Our taxable fixed income portfolios on average produced a +10.2% return thus far in 2019. These are strong year-to-date returns and we do not expect similar returns in the years ahead. There is limited opportunity to safely deploy capital at yields much above 4%, this does not bode well for incremental investments in the corporate bond sector.
Today, our corporate bond portfolio has a yield to maturity of 4.70% with an average maturity of 4.9 years. We added one new bond position to the portfolio just after quarter end – Cleveland Cliffs 5.75% due 2025. We purchased this bond at a 6.33% yield-to-maturity. Opportunities like this are fleeting and we continue to struggle to replace maturing high yielding bonds with those of a similar yield profile.
Our municipal bond portfolios on average has delivered a 4.8% return for 2019. Today we’re able to purchase municipal bonds with maturity of 10 – 12 years at yields of 2.5% – 3.0%.
We completed a small follow on investment during Q3 and added to our Boise, Idaho self-storage portfolio.
Overall our real estate portfolio continues to perform well and is expected to deliver attractive returns for the balance of 2019. A more detailed description and update can be found in the “Real Estate Update” included with this letter.
A detailed update on our current holdings can be found in the “Private Equity Update” included with this letter.
We have enjoyed strong returns across our public equity, fixed income, real estate and private equity investments thus far in 2019. I have run out of “storm clouds on the horizon” analogies to use so I will close with this – we continue to emphasize capital preservation, quality, discipline, and research rigor with the belief that this approach will serve us well in calm or stormy seas.