Interview with SA: Investing in health with a fundamental diagnosis

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Background interview

Fundamental Diagnosis is an individual investor and former sell-side healthcare analyst at several major investment banks. We discussed how to use DCFs as an assessment framework, why downstream effects on inflation are more important than COVID as a catalyst for the market, and how to better assess statements made by experts or other investors.

Looking for Alpha: Tell us about your investment decision-making process. Which market sector do you focus on and what strategies do you employ?

Fundamental Diagnosis: I guess you could call me a value investor. I look for companies where the present value of future cash flow forecasts significantly exceeds the company’s current market value. I spend a lot of time planning the fundamentals. I also try to keep some degree of perspective on the macro image. Although I personally invest in the broader market, my expertise is in healthcare, which is what I write about.

HER : To continue, given the scope of the healthcare sector, do you focus on certain industries? If so, which ones and why? Are there more pricing errors in certain sectors or market cap sizes?

Fundamental Diagnosis: The one part of healthcare where I feel out of place is small biotech, where stock price movements are often more tied to clinical data, and actual cash flow can take years. I think it’s possible to get the wrong prices across all cap sizes and all industries. COVID has brought a lot of attention to the sector and created some interesting opportunities, where new investors have entered the sector without fully understanding some of its idiosyncrasies.

HER : Can you explain how a thorough competitive analysis can reduce risk and/or serve as a source of idea generation? Can you give an example?

Fundamental Diagnostic: Truly understanding all the competitors in an industry takes a ton of time, so many analysts have cut that corner. But if you really dig, you can sometimes gain an advantage by realizing that the competition has less bite than it first appears, or that the competition is more robust than you first thought. An example of the first category is next-generation sequencing, where I believe the titular Illumina (ILMN) is far more immune to new competitive threats than the hype surrounding these small companies suggests. An example in the latter category is generic drugs in the United States, where competition over the past five years has become much more problematic for large incumbents like Teva (SUITS YOU) and Viatris (TRV).

HER : How should investors use a company’s investor presentation in the research process? In general, what mistakes do you see investors making here?

Fundamental Diagnosis: You need to understand that companies are not impartial. They will present information that flatters them, and they don’t have to present from every angle. However, these documents sometimes contain information that does not appear in the documents filed. My general recommendation is to compare what all companies in the same industry put in their documents. If Company A says the market is growing by 5%, Company B says 8%, and Company C says 10%, try to understand why these differences exist. Do they serve different parts of the market? Do they refer to different sources? Does management legitimately have a differentiated view of the market?

HER : Can you tell us about your valuation framework for investing in the healthcare sector? What are the best practices for using DCF models?

Fundamental Diagnosis: I try to think of stocks the same way I think of bonds. What is the return on the stock based on the cash flows that stock investors are entitled to. (The additional step in equities is to assess whether management will deploy this capital prudently). DCFs are useful in determining the performance of a given forecast. DCFs are too sensitive to multiple variables to be too specific about price targets. But it is possible to say “given this set of forecasts, the current stock price suggests a return of about x%”, where x is the discount rate. Then you can compare that to Treasuries, corporate bonds, or other stocks to make useful asset allocation decisions.

HER : Can you explain how focusing on the overall narrative of a stock and/or sector can be beneficial or harmful? Can you give an example?

Fundamental Diagnosis: It’s really striking how storytelling can go completely beyond the fundamentals at times. Maybe it’s because as social animals, humans are just hard-wired to pick up on a good story. In healthcare, you’ve seen it with a stock like Moderna (MRNA), where the reality of the cash forecast just didn’t live up to the extreme hype at the height of COVID. In the broader market, you saw it with hypergrowth technology, where narrative clearly trumped actual cash flow until reality started to set in about a year ago year. This sort of thing is playing out all over the market. Electric vehicles will not replace ICE fast enough to justify recent assessments. Fintech won’t be as disruptive to legacy finance as valuations suggest. Oil and gas won’t disappear in a decade, as 2020 valuations suggest. Investing in a narrative is easy. It’s much harder to make real predictions, but that’s how the money is made.

HER : Since the onset of the COVID crisis, investors have heard many different opinions on the subject – how can they better evaluate the statements made so that they can make a more informed decision (or even gain an advantage when investing) ? Can you give an example?

Fundamental Diagnosis: It was a little easier at the start of the crisis to spot obvious mistakes, like the assumption in mainstream media at the time that a vaccine would be a decade away. Everything is more complicated now, and I would argue that COVID is not a major catalyst for the market or even for individual stocks at this point. The downstream effects on inflation are much larger today. My general advice is this: first, find reputable sources of information. In the field of health, I like Stat News, for example, but I also look for obscure blogs written by asshole experts. Second, try to compare the decision you make from the “outside perspective” with the decision from the “inside perspective.” These are terms super-forecasters use to distinguish between looking at the forest and looking at the trees. I tried to figure out how the opioid colonies are going to shake up the generic companies. The outside gaze tells me colonies will occur and they will be manageable. The inner view tells me that things are much more complicated than they first appear, and perhaps I shouldn’t be so confident in the outer view. I still don’t know which will prevail, but I feel like this kind of perspective gives me a good idea of ​​the situation.

HER : What is one of your most compelling ideas right now?

Fundamental Diagnosis: I wrote about Organon (OGN) on Seeking Alpha as a high conviction idea. That hasn’t changed. The stock has not moved much, despite improving fundamentals. It is a spin-off from Merck that trades very cheaply. People sell it to generic companies, but it has none of the legacy and legal issues those companies face. I like this management team. I think they’ll be able to build a portfolio of women’s health products cautiously, and they’re already executing that strategy. I still think it’s a double over a multi-year horizon.

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Thanks to Fundamental Diagnosis for the interview.

The basic diagnosis is long TEVA, OGN and short mRNA.

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