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Cutting Through The Rhetoric In Pharmaceutical Stocks

By Mustafa Sagun, Chief Investment Officer, Principal Global Equities It’s easy to get wrapped up in the headlines when it comes to investing. But for long-term investors, it’s important to separate rhetoric from reality. This was demonstrated most recently in the public outrage over Turing Pharmaceutical’s decision to raise the price virtually overnight on Daraprim, a drug that treats the parasite infection tonoplasmosis, from $13.50 a pill to $750 a pill – an increase of 5,000%. According to industry estimates, drugs such as Daraprim usually see a 3% to 20% annual increase. The decision made on September 21 by the firm was pounced on by presidential candidates, such as Hillary Clinton who proclaimed, “Price gouging like this in the specialty drug market is outrageous. Tomorrow I’ll lay out a plan to take it on.” It wasn’t long before the company reversed course on its product price increase, but nevertheless, the damage had been done as the firm’s decision to increase the price of its product had worked its way into financial markets, particularly impacting healthcare stocks. Since then (September 21 to October 6), the S&P 500 healthcare stocks underperformed the S&P 500 index by about 5%, giving back its year-to-date outperformance. This was mainly driven by ETF selling, as evident from high transaction volumes in key healthcare ETFs (see portfolio insight for more on why ETF selling is an opportunity for fundamental stock pickers). Political rhetoric aside, let’s take a closer look at the reality in this situation to determine if there’s any real negative impact to the fundamentals of healthcare company stocks. The Reality: The reality is that there’s no regulation without legislation. More specifically, there’s no legal way for a sitting president, or any political candidate for that matter, to regulate drug pricing in the United States. Only a change in current laws could do that! And bipartisan legislative action is highly unlikely for at least the next two years or for that matter, perhaps even longer. The other reality is that financial fundamentals are better than ever for biopharmaceutical companies. Business models, product offerings, pipelines, and management quality are considerably better now than they were 10 years ago, resulting in sustainable earnings growth for these companies that is superior to most other sectors of the S&P 500. Another key point is that earnings are stable, as are earnings estimates and guidance. While some stock prices are down more than 20% since mid-summer highs, valuations are attractive and, in fact, quite compelling on a PEG (price earnings per unit of earnings growth) basis. So, the relative underperformance experience cannot be explained by earnings and fundamentals. Rather, the fact of the matter is that short-term concerns, without earnings support, create opportunities for long-term investors. Granted, the healthcare sector has been a long-term winner within the S&P providing a 21% annualized return versus 15% for the S&P 500 since 2012; thus, a pullback is normal. However, we should still recognize that the healthcare sector trades at a lower multiple than the market as a whole while providing higher earnings – two sought out characteristics for fundamental investors. Our healthcare analysts acknowledge that the cloud of uncertainty over drug prices may persist for some time. However, we believe this is an opportunity to take advantage of cheap valuations in companies with improving earnings and fundamentals, as fundamentally nothing has really changed for these companies. They just got cheaper! Portfolio Insight: Focusing on Company Fundamentals As long-term, research-driven fundamental investors, we try to cut through all the rhetoric to focus on the company-specific information that affects earnings and valuations. We believe that it’s important for long-term investors not to paint an entire sector, and every company within that sector, with the same brush. After all, ETF selling by thematic investors is an opportunity for fundamental stock pickers. In other words, a healthcare ETF sells all stocks based on their association to the sector, whereas fundamental investors may buy back a select few due to their superior fundamentals. That’s the essential nature of a bottom-up stock picker; remain calm, stay the course, and focus on sustainable earnings growth that has valuation support. At the end of the day, we seek out opportunities to exploit the behavioral biases that hype and rhetoric create. (click to enlarge) While there are near-term headwinds stemming for the drug price control rhetoric from democratic candidates, fundamentals and earnings have not changed and the recent price weakness has provided further valuation opportunities.

Top ETF Stories Of September

The third quarter of 2015 was utterly downbeat for the broader U.S. market as well as the global indices with the China-led rout surfacing in August and spilling over into September. Not only global growth worries but also high speculation of a Fed lift-off has made the month of September the most-watched one so far this year. In any case, according to the Stock Trader’s Almanac , September ended in red 55% of the times while S&P Dow Jones Indices indicated an average fall of 1.03% return over the last 87 years in September. As a result, after a worldwide investing massacre in August, the investing cohort must be keen to know the top financial stories of September and check their impact on the ETF world. Still a Dovish Fed Turning loads of hearsays off, the Fed remained supportive in its most talked-about September meeting. A dreaded uproar in the global investing backdrop in August led by the Chinese market crash, swooning commodities and their shockwaves on other emerging economies held the Fed back from switching on the lift-off button this September. Muted inflation and a still-strong greenback were also other forces to inhibit the Fed from policy tightening. As the Fed stayed put, some big moves in various markets and asset classes were prompted. Though the Fed has kept the option for a 2015 hike still alive, a small section of policymakers and traders have started to bet that the rates may not be hiked before 2016. Whatever the case, financial ETFs like SPDR S&P Regional Banking ETF (NYSEARCA: KRE ) and iShares Broker Dealer ETF (NYSEARCA: IAI ) and U.S. dollar ETF PowerShares DB US Dollar Bullish Fund (NYSEARCA: UUP ) were the foremost losers post Fed meeting. UUP shed 0.04%, KRE lost 1.1% and IAI was off 6.4% in the month. However, there were plenty of gainers too. Long-term Treasury bond ETFs like Vanguard Extended Duration Treasury ETF (NYSEARCA: EDV ), high-yield m-REIT ETFs like iShares FTSE NAREIT Mortgage Plus Capped Index Fund (NYSEARCA: REM ) and gold-related ETFs like SPDR Gold Shares (NYSEARCA: GLD ) and Market Vectors Gold Miners ETF (NYSEARCA: GDX ) added gains post meeting. Overall, EDV was up over 1.5% in the month but other products could not hold on to gains. REM was off 4.2% while GLD and GDX shed 0.45% and 5.6% in the month (as of September 28, 2015). Biotech Meltdown If China made August infamous, biotech did the same for September. Pricing issues in the biotech space has long been a concern but came into the limelight in September following a tweet by the Democratic presidential candidate Hillary Clinton. Her tweet raised concerns on over pricing on life-saving drugs at the end of the month. Questions over biotech pricing came on the heels of a 5,455% price hike (in about two months) of a drug called Daraprim, used to treat malaria and toxoplasmosis. This gigantic leap in pricing action was taken by a privately held biotech company Turing Pharmaceuticals. Not only Turing Pharmaceuticals, Valeant Pharmaceuticals International Inc. (NYSE: VRX ) is also likely to be summoned by Democrats on the House oversight committee for hiking 525% and 212% prices for two heart drugs. The talks pulled VRX shares down by 16.5% on September 28 and hit all biotech ETFs. In fact, growing pains for biotech investing led the biggest related ETF iShares Nasdaq Biotechnology (NASDAQ: IBB ) to incur the largest weekly loss in seven years. IBB was down over 15% in the last one month while ETFs like SPDR S&P Biotech ETF (NYSEARCA: XBI ), Medical Breakthroughs ETF (NYSEARCA: SBIO ) and BioShares Biotechnology Clinical Trials Fund (NASDAQ: BBC ) were off 15.4%, 16.5% and 15%, respectively. Volkswagen Scandal This dealt quite a blow to the entire auto industry. The iconic German carmaker Volkswagen AG ( OTCQX:VLKAY ) has been accused of tricking on the Environmental Protection Agency (EPA) test. Per EPA, Volkswagen had set up a software algorithm which allowed it to mislead U.S. emissions tests and the carmaker has admitted the charge. This immediately weighed on the key auto industry of Germany as other automakers have also been hit. Germany ETFs like iShares MSCI Germany ETF (NYSEARCA: EWG ), Recon Capital DAX Germany ETF (NASDAQ: DAX ), Germany AlphaDEX Fund (NASDAQ: FGM ) and db X-trackers MSCI Germany Hedged Equity Fund (NYSEARCA: DBGR ) were hit hard on this car scandal and registered a steep retreat in the month. The funds were off over 6.6%, 6.5%, 6.4% and 5.15 respectively in September. Original Post Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Prime Minister Tsipras Resigned, The Greek Parody Is Set To Continue

Summary Prime minister Tsipras resigned, new elections are expected in September. A new anti-austerity Popular Unity party to be created. GREK investors should expect increased share price volatility and potentially new lows. The Greek parody seemed to come to an end finally. But the recent developments show that another act has only begun. Although opponents of the austerity measures were victorious in the referendum that took place in early July, the Greek government agreed to adopt reforms and austerity measures demanded by the creditors, in order to avoid the looming state bankruptcy. On July 15, the Greek parliament approved bailout measures with 229 out of the total of 300 votes. The measures included increase of value added tax, limits on public spending and reform of the pension system. As a result, €86 billion should be provided to Greece over the next three years. The reaction of the Global X FTSE Greece 20 ETF (NYSEARCA: GREK ) was positive at first, but the share price decline resumed very quickly due to the uncertainty as to whether the new financial package for Greece will be approved by the creditors. There are 19 countries in the eurozone and in 8 of them (Austria, Germany, Greece, Estonia, Finland, France, Latvia, Slovakia) the parliament had to decide whether the country will vote for or against the bailout package. Things started to look brighter in August, as it began to be clear that the bailout package will be approved. On August 18, Fitch upgraded the Greek credit rating to CCC, on August 19, the German parliament approved the bailout package. Germany was the last country to approve the package. It seemed like the Greek problem has been resolved (swept under the carpet) for now. But another of the countless surprises was prepared by the Greek government on August 20, when prime minister Tsipras resigned . According to Reuters, the new elections should take place on September 20. Tsipras wants to support his position and get rid of the opposition inside his own party. According to BBC , 25 members of Syriza plan to create a new Popular Unity party, led by the former energy minister Panagiotis Lafazanis. The situation may get really complicated, as the July referendum showed that a majority of Greeks opposes the austerity measures. If the new anti-austerity party gains too much power, all the bailout process may be endangered. After Tsipras won elections in January 2015, he said that his government doesn’t feel obliged to fulfill commitments of former Greek governments. If the new government behaves the same way, the Greek parody may start over again. Source: own calculations, using data of YahooFinance It is highly probable that the relatively calm couple of weeks have ended for GREK. Volatility measured by the 10-day moving coefficient of variation (chart above) was relatively low over the last couple of weeks, as it ranged from 1% to 4%. But GREK investors should prepare for another turbulent period ahead. GREK’s share price development will be driven mainly by the pre-election polls. The most vulnerable part of GREK’s portfolio continues to be shares of Greek banks, however their cumulative weight declined to approximately 12%. The banks are in a complicated situation, as the eurozone finance ministers declared that bail-in of depositors will be explicitly excluded. It means that the Cypriot scenario shouldn’t repeat in Greece. But the bondholders are endangered. This decision should prevent bank runs and increase the trust of depositors in Greek banks. On the other hand, Greek banks will have even bigger problems to raise money via bond markets. Conclusion The situation in Greece is getting more complicated once again. If the anti-austerity parties win the coming elections, it is hard to predict what may happen. GREK investors should be prepared for another weeks of increased share price volatility and it is quite possible that new lows will be created. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.