Paul Sutherland regularly writes in these newsletters about the ever-changing world and how as investors we need to be acutely aware of such changes. Today, there is no shortage of BIG TIME change staring investors smack in the face. Two of the more significant of these changes under way today are shifts in demographics (aging in many developed countries, growing youth populations elsewhere) and central bank policies (from extraordinary, coordinated easing to eventual tightening). Yet perhaps even as massive, or more, in scope is the Fourth Industrial Revolution that Paul mentioned in last month’s newsletter.
To recap for those who missed his article, World Economic Forum founder Klaus Schwab describes this Industrial Revolution #4 (IR4) as “the fusing of the physical, digital, and biological worlds, impacting all disciplines, economies, and industries, and even challenging ideas about what it means to be human.” Already, the early innings of IR4 are clearly upon us. Not a day goes by without a barrage of headlines announcing new breakthroughs in automation, artificial intelligence, advanced materials, big data, miniaturization, robotics, and precision medicine. As client questions regularly come up related to how the FIM Group team invests amid the significant technology changes under way, I thought I would explore the topic this month. Specifically, I’ll get right to how our team is thinking about the risks and opportunities with technology investing today and will offer some examples of our holdings in these areas.
Being risk managers first and foremost, we’ll start with two concerns related to technology stock investing that any value-focused manager can’t ignore. First, the growth potential in high- profile IR4 areas is already well known among the speculator and investor community. Many are chasing the most visible leaders in these areas and driving related stocks to eye-popping valuation levels. As a simple proxy and to give you a sense for the magnitude and duration of the stock outperformance in tech-land, the figure on the next page shows the relative price performance of the broad-based Wilshire 5000 stock index (essentially, all listed U.S. stocks) against the tech-heavy Nasdaq 100. Just as we saw two decades ago, a clear gap has emerged between tech stocks and the broader market.
While the valuations of tech stocks today, on average, remain below where they were back in the late ’90s tech bubble, they are still pretty lofty. Nasdaq 100, for example, is currently priced at around 20x expected 2017 earnings, and well-known constituents like Netflix (141x) and Amazon (236x, not a typo!) trade much higher. Those with investing memories that hark back to the cuckoo days of the Y2K tech boom might recall that Cisco and Microsoft also once commanded 100x-plus price/earnings ratios. When investors finally stopped drinking the “unlimited growth ahead” Kool-Aid, their shares came crashing back to Earth. It took Microsoft 15 years to recover its tech bubble peak share price, despite the company’s sales rising 4x from 2000 levels. With Cisco, its sales have more than doubled over the last 17 years, yet the stock remains 60% below its year 2000 high. The risk management reminder here: Great companies exhibiting significant current growth trends can be lousy investments if the price paid (valuation) reflects irrational expectations for the future.
A second risk we concern ourselves with in the IR4 area is how these technologies threaten the business models of both existing and potential portfolio positions. Our FIM Group colleague John Bresnahan noted just a sampling of the questions we regularly discuss as a team and pose to the executives running our portfolio companies; he wrote about them in an article that we posted earlier this year (see his article The Opportunist in Search of Ubiquity in FIM Group’s January 2017 newsletter at fimg.net). These questions cover topics including the effect that IR4 trends have on executive decision-making, the impact these trends place on the competitive landscape, and the resulting pitfalls and opportunities that are emerging for companies of all sectors. As Professor Schwab noted in the quote above, it is hard to come up with a sector or company that is immune to technology disruption. Many companies are making proactive investments to stay relevant in an IR4 world, while those that are slow to adapt or that lack the balance sheet to do so face serious challenges. Traditional retailers stand out on this front (stocks like Macy’s and Sears are down 70%+ in just the last two years), but even companies with regulatory protection long perceived as “safe” for investors (for example, energy utilities and insurance companies) face not-so-distant challenges from companies that are leveraging technology and bringing new approaches to old industries.
For the opportunity side of the IR4 equation, despite the valuation challenge with the popular tech stocks noted above, there remain plenty of options for us at FIM Group to pursue without violating our value discipline. We are doing this by investing in complex conglomerates with technology sector exposure that’s underappreciated by the market. We are also investing in smaller, niche companies that fall off the radar of many institutional investors but that stand to benefit from the investments they are making and the innovations they are bringing to their respective sectors.
One example of the former (conglom- erates with underappreciated technology exposure) is a Japanese company I visited on a recent research trip and discussed during our August webinar. You may know Softbank as the majority owner of U.S. telecommunications company Sprint. What you may not know is that the largest component of Softbank’s fundamental value is its nearly 30% ownership of China’s answer to Amazon, Alibaba. Softbank CEO Masayoshi Son first invested $20 million in Alibaba back in 2000. Today, even after paring back the stake, Softbank’s ownership is worth over $100 billion. Son has since been on an IR4 investing rampage of sorts, buying stakes in a wide range of satellite, robotics, automation, agricultural technology, and artificial intelligence companies. In the past year, he also gathered up investors to co-invest with him in a $100 billion Vision Fund. Softbank will be a major investor in the fund and will earn fees from the other partners that sign on.
On the much smaller, niche company front, we own companies that have embraced the early technology innovations of IR4. These companies are using and developing such technologies for various goals. Some are deploying new technologies in conjunction with complete business model overhauls. Others are integrating state-of-the-art technologies into existing products to gain first-mover advantages. And many are leveraging the latest technology breakthroughs to apply entirely new solutions to some of the world’s most pressing challenges.
Gaia, for example, a portfolio company on whose board Paul serves as a director, has an entirely new business model, thanks to the ubiquity of low-cost streaming video technologies and digital marketing tools. Its legacy business, which included the distribution of health and wellness media and related products (think “yoga CDs and accessories”), was largely sold over the last few years so that the company could focus purely on its SVOD (streaming video on demand) subscription services. Already, nearly 300,000 subscribers pay $10 per month to access 8,000+ titles in niche areas like yoga, personal transformation, and paranormal encounters. Revenues will likely grow at least 50% this year, with expectations of a similar pace in 2018.
Carmanah is a Canadian company best known for its leading position in solar- powered LED navigational aids (things like marine lanterns, railway signals, and offshore wind turbine lighting) used in the harshest of conditions.
Management is leveraging its know-how in processor technology and rapidly declining prices in solar panels, batteries, LEDs, and sensors to launch first-of-its-kind, grid-competitive, off-grid general illumination products. Its newly launched Evergen series of lights for things such as roadways, parking lots, and walking trails eliminates electricity bills as well as costly trenching and wiring. These products also feature smart sensors and satellite connectivity to allow offsite monitoring and data gathering. The same satellite connectivity is already being embedded in the company’s legacy infrastructure lighting products. For example, navigational buoys placed in the ocean that previously required a technician to physically verify the status of positioning and battery power can now be checked remotely with Carmanah’s LightGuard Monitor.
In healthcare, Ellex, an Australia-listed company, continues to develop new approaches for the fight against blindness. Its laser-based therapies are used to treat glaucoma, diabetes-related retinal disease, cataracts, and macular degeneration. Two of its most recent innovations are a microcatheter device used in minimally invasive glaucoma surgery and the 2RT Laser, a new retinal-cell rejuvenating therapy that aims to slow down Age-Related Macular Degeneration (and to delay the need for direct eye injections). The target market for Ellex’s products is over $10 billion as populations age and access to healthcare improves globally.
For those wondering how FIM Group invests amid the massive technology changes swirling around us, I hope this summary has given you a bit more color. Although our value discipline makes some of the more popular technology companies difficult to own at today’s prices, we continue to find highly promising investments. Some of these are hidden in complex conglomerates, while others are stand-alone companies with compelling prospects that have yet to be priced out of our comfort zone by larger institutional investors and speculators. I’ll close with mention of Peter Diamandis, founder of the XPRIZE Foundation and the author of Abundance–The Future Is Better Than You Think. His Abundance Insider is a free weekly email (www.diamandis.com to subscribe) that may open your mind to the positive possibilities ahead for us in this IR4. I look forward to reading it each week, just as I look forward to our investment team’s regular discussions in many of these very exciting areas.
September is upon us, and soon after, the busy holiday season. Believe it or not, it’s not too early to prepare for tax time. Toward the end of the fourth quarter, whether you are a wage earner, self-employed, or retired, you should have a good idea what your annual income and expenses will be. If you rely on investments (dividends, interest, and capital gains) as a portion of annual income, feel free to contact one of our offices to learn what your year-to-date figures are. Although these are likely to change by year end, it’s good to have this information before scheduling a meeting with your tax professional. Most wait until January or February to begin “tax preparation” – gathering receipts and tax forms, finishing up QuickBooks entries, completing the annual tax planner, and so on. Unfortunately, by then it’s too late to consider a Roth IRA conversion. Unlike a regular Roth IRA contribution, where you have until the tax filing deadline to contribute (and is limited, based on Adjusted Gross Income thresholds), a conversion must occur by December 31st.
I have learned most clients build the majority of their retirement savings in tax-deferred accounts – IRAs, 401(k)s, 403(b)s, Profit-Sharing Plans, and Defined-Benefit Plans. Yet when retirement comes, or income goes down, converting assets from tax-deferred status to a tax-free Roth IRA is a tax- planning tool often neglected. Given the “5-year” rules on conversions – where conversion assets must remain in the Roth IRA for four to five years, with a few exemptions not subject to the 10% early withdrawal penalty – it makes the most sense to convert between the ages of 591⁄2 to age 70 and beyond. I advise clients that when you find yourself in a low tax bracket, converting may provide significant tax savings over the long run.
Combined gross income for a newly retired, 66-year-old couple has dropped from $200,000/year to $60,000/year. The income they now receive is from Social Security (which they delayed to Full Retirement Age, or FRA), and investment income from dividends. Because they planned well, saved a large amount to their retirement accounts, and have reduced their at-retirement monthly expenses, they have no need for additional income. They also find themselves in a much lower tax bracket, which, according to their Certified Financial Planner, provides a wonderful opportunity to convert a portion of their tax-deferred funds to a Roth IRA. By converting in a lower tax bracket, hey have essentially locked in their tax liability, so the funds grow tax-free, regardless of what tax rates may be in the future. In addition, if the tax- deferred accounts have dropped in value, converting may provide additional tax-saving benefits.
Another wonderful benefit of your having a Roth IRA is that you are not forced to take Required Minimum Distributions (RMD) at age 701⁄2. For retirees, you must take your first distribution from tax-deferred accounts that year, or by April 1st following the year you turn 701⁄2, whether you need the money or not. Having assets in a Roth provides added flexibility, where you are in control of the amount you take, as needed, and the funds continue to grow tax-free.
If you are unsure whether a Roth IRA conversion makes sense for you, please contact one of our Certified Financial Planners or discuss with your tax professional before year-end. A conversion depends on one’s unique, financial situation, and there are additional rules and limits to consider.
Company Description: Roche was founded in 1896 by Fritz Hoffmann-La Roche and remains based in Basel, Switzerland. With operations spanning the globe, Roche employs approximately 94,000 employees spread across 22 research and development sites and 26 manufacturing sites.
Roche’s business (50.576 bCHF in 2016 revenues) is broken into two segments, Diagnostics and Pharmaceuticals; revenues are roughly 25% and 75% respectively. Within the Pharmaceuticals division, Roche is active in Oncology, Immunology, Ophthalmology, Infectious Diseases, CardioMetabolism, Neuroscience, and more.
In 2016, some 27 million patients were treated with a top-25 Roche medicine, 128 million patients received a Roche off-patent medicine, 17 billion Roche diagnostics tests were performed, 74 new medicines were in development, and 29 Roche drugs made the World Health Organization Essential Medicines List.
Roche’s research and development (R&D) investments for 2016 were 9.915 bCHF, or about 20% of its 2016 revenues, and greater than 50% of its 2016 operating profit of 18.42 bCHF. Roche’s R&D partnerships (200+) account for 45% of its pipeline and 37% of its pharmaceutical sales.
Investment Thesis: Our investment case for Roche is three-pronged. Foremost, we believe it has constructed an ever- expanding moat through its peer- leading R&D investments. Second, we believe the company’s governance and ethics are industry-leading. Finally, we believe its strong strategic vision and balanced business model are unmatched in the industry.
In 2016 Roche spent more on R&D than it ended the year with net income: some 9.9 bCHF vs. 9.7 bCHF. This is extremely rare in the pharmaceutical industry, often only found in early-stage bio- technology companies that are burning through cash in the hopes of bringing a single agent to market. In absolute terms, at 9.9bCHF Roche is Number 1; we find comfort in an entity that is willing to reinvest such a large portion of the revenues so consistently.
In our estimation, this reinforces a moat that is sturdy both in keeping competition in check and in keeping regulators pleased. Consistently, Roche has shown a propensity to be judicious with its pricing and the inflation thereof; while it boasts some of the largest drugs (by sales), they will often be found toward the bottom of the list when considering price increases over time.
In today’s world of instant dissemination of sometimes hyperbolic (perhaps misleading) headlines, we find comfort in Roche’s strategy.
The second leg of the Roche case is governance and management, though if we expand this to Environmental, Social, and Governance (ESG) we will surely find comfort. The founding family of Roche remains in control of the board through a dual-share structure. This has meant that long-standing beliefs and purpose have remained – that is, Roche is able to take the long-term perspective and to invest for the future. (The phar- maceutical industry is rife with execu- tives looking to build a legacy, often through big bets and a slash-and-burn approach to their former strategic goals. This is something we would like to avoid as investors, because that all translates to a lot of cash being “burned” and not returned to investors.) We welcome the stability that the board at Roche brings to what can be a volatile industry.
A question comes to mind, which defines the third leg of our interest in Roche: “How do you invest in healthcare?” More broadly, how do we as investors balance the push-pull between internal and external forces? The healthcare industry is heavily regulated; even that statement is generalized, as each region and market differs materially. Getting a new drug approved in the U.S. versus Europe versus Japan requires scale, expertise, and a strong moral and ethical frame- work. You’ve also got the best and smartest competition in the world, often well-funded (just to round things out), and, of course, patents can roll off and trials can fail.
In our opinion, an entity that has managed to balance shareholder and stakeholder needs for more than a century is vital. A robust pipeline, like that of Roche, is good for the shareholders, reassuring for the employees, and great for humanity.
With a broad pipeline, we believe Roche can weather R&D failures, competition, and increased regulatory scrutiny.
Forgoing larger profits today, while investing for tomorrow, Roche is ensuring that it will be around for another century. Through Roche we gain exposure to global demographic megatrends, solid growth, an ever- increasing dividend, and all at a discount to peers and historical valuations. Given that Roche might just be the highest- quality pharmaceutical company in the world, we are glad to build a core position in your portfolios at what we believe to be reasonable valuations.
We estimate the Roche business model to be economically robust and able to (on average) give us strong shareholder value/yields for years to come. Roche is an innovator that has generated great shareholder value through market cycles, and we expect the same going forward. Nonetheless, we will closely monitor the company to ensure that none of the qualities that make it great are eroding.
For those interested, here is a link to Roche’s pipeline: http://www.roche.com/ research_and_development/who_we_are_ how_we_work/pipeline.htm
Sources: Company, Bloomberg
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