Get ready for a torrent of mergers in the health-care patch.
That’s one big takeaway from a wide-ranging discussion with Ethan Lovell and Andy Acker, the co-managers of the $3.8 billion Janus Henderson Global Life Sciences fund (ticker: JAGLX).
Big Pharma companies and leading biotechs, such as Amgen (AMGN), are always looking for smaller companies with exciting late-stage drugs to acquire in an effort to boost earnings growth. Their merger-and-acquisition efforts received a new supply of oxygen in the form of billions of dollars of repatriated profits, thanks to the recently passed tax-code overhaul.
“The CEOs of these companies on recent conference calls have basically told investors that the top priority for this new-found access to cash is to make acquisitions,” says Lovell.
Acker adds, “In the past two weeks, we have had three companies within our portfolio that have agreed to be acquired by larger companies, and all three of those were at significant premiums.”
Over the past five years, Life Sciences, a no-load fund with a 0.93% expense ratio, has delivered a 17.5% annualized return, besting the average health-care fund in Morningstar’s database by 2.2 percentage points.
We asked Lovell, 50, and Acker, 45, to share their thoughts about several companies that are doing the kind of innovative work the big guys want, as well as other big developments roiling the health-care sector—including news that three major U.S. companies are banding together to launch a health-care company for their employees.
Barrons.com: Let’s begin by addressing health care’s role in the big stock selloff over the past week or so. Companies in this sector, particularly in biotech, have fallen more than the broader market. Has this return to volatility altered the way you look at the space and what you’ll buy?
Ethan Lovell: While we don’t tend to make dramatic changes in our portfolio construction off short-term, market-oriented fluctuations, we’ll generally look to add selectively where we see particularly accentuated dislocation. Given our belief that this could be a good year for biopharmaceutical M&A, we would expect to be looking to add to our highest-conviction ideas in the innovation part of the portfolio.
Q: Let’s talk about stocks that embrace innovation.
Andy Acker: In biotechnology, we’re seeing the greatest innovation that we have seen in more than 20 years of covering the industry. Just as an example, there were 46 new drugs approved in 2017 in the U.S.—the most in 20 years.
Q: Give me an example of a company you think has embraced innovation more effectively than others.
Acker: I’ll give you a couple of ideas that we’re excited about where they’re making significant progress. One is in the area of immuno-oncology. There are companies that have figured out ways to harness the power of the immune system to attack and kill cancer cells.
The initial therapies are called either PD-1 inhibitors or PDL-1 inhibitors, from companies likeMerck (MRCK), Bristol-Myers Squibb (BMY), and Roche Holding (ROG.Switzerland). In previously incurable cancers, for a meaningful percentage—generally about 20% of patients—they’re getting long-term functional cures, or long-term functional remissions that could be cures. Those therapies this year will sell over $10 billion and are having a dramatic impact on patient care. They’ve been approved for a wide variety of indications from lung cancer to kidney cancer, to head and neck cancer.
Q: So what’s a biotech that is at the forefront?
Acker: One company that people are excited about today in the market is Nektar Therapeutics (NKTR) [which has a market cap of about $11.5 billion]. It was a small-cap not too long ago.
The holy grail today in the industry that everyone is looking for is what can you combine with one of these PD-1 inhibitors to make them work better—meaning to help them work in either a broader group of patients beyond the smaller subset or even to work better in that subset.
What Nektar has done is they’ve used their technology to create an altered version of an older drug, IL2, that can be better tolerated and yet still potentially activate the immune system.
So although the data is very early, it’s been very exciting to the field because it looks like, when you add this drug to these PD-1 inhibitors that are rapidly becoming the standard of care, they can actually enhance and broaden the efficacy of those therapies. If these data hold up as we see a larger data set, we think this could become one of the very important new medicines in this field of immuno-oncology.
Q: Thanks to the new tax law, a lot of big drug and biotech companies plan to use repatriated profits from overseas to take over smaller companies.
Acker: M&A currently is a big theme for us. In fact, in the past two weeks, we have had three companies within our portfolio that have agreed to be acquired by larger companies, and all three of those were at significant premiums.
Lovell: The Big Pharma companies that would be making these acquisitions, including some of the big biotech companies, are struggling to find late-stage development candidates beyond what is necessary to continue the pace of growth they’ve experienced longer term. The pipelines of these companies are decent, but they could be improved. Point No. 2, they now have full access to not only the cash they had held overseas, but cash flows that could be used to support expanding credit to be able to make acquisitions. The CEOs of these companies, in recent conference calls, have basically told investors that the top priority for this newfound access to cash is to make acquisitions.
Also, interest rates remain low, even though they are increasing. So if you look, for example, at the two transactions that involved Sanofi (SNY) making acquisitions—announcing plans to buy Bioverativ (BIVV) and Ablynx (ABLX)—its access to capital is such that they’re going to be financing that with a 1% interest rate. So that is a pretty good lubricant when it comes to making acquisitions.
Finally, the tax rates for not only U.S. companies but also for foreign companies doing business in the U.S. has come down dramatically, which makes these much more valuable assets. In the pharmaceutical industry, half of the profits come from the U.S. market, and you just had the corporate rate drop from 35% to 21%.
Acker: Last year, uncertainty about tax reform was holding back M&A activity. Now that we have tax reform and the rules have been clarified, we would expect M&A activity to resume. One thing that we’ll see now, with this recent market pullback, is whether that could create a little more uncertainty, so we’ll have to see if this continues or if the market stabilizes.
For example, Amgen alone has $39 billion of cash that was located overseas that they will now have full access to. The company is planning to buy back $10 billion of stock in the near term, but then they’ll still have room to do acquisitions on top of that, which they probably will need to do to accelerate their revenue growth.
Q: Is Nektar a potential takeover candidate?
Acker: Nektar is rumored to be the target of some interest from larger pharmaceutical companies.
Q: What are some other examples of small- to mid-size biotechs that could be acquired in the next six months?
Acker: There are different flavors of stocks that we’re investing in. Some of them are companies that already have an FDA-approved product with successful clinical trials and regulatory approval, and now the question is how big that market is going to be. One company I would put in that category would be Neurocrine Biosciences (NBIX), which has a new launch this year for a disease called tardive dyskinesia, which is a movement disorder. So far that launch has gone very well and they’ve been exceeding consensus estimates, so we’re excited about that product.
They have a second product, partnered with AbbVie (ABBV), that should be approved next quarter, for the treatment of uterine fibroids.
Q: What’s another investment theme you like right now?
Acker: The opioid crisis has become a national emergency. We have several new companies that are developing new therapies that we think can help to address the problem.
Q: Give me one example.
Acker: There’s a company called Heron Therapeutics (HRTX). They’re developing a drug for postoperative pain that could potentially reduce the need for opioids after surgery.
It’s not addictive at all. It’s a combination of two drugs that are essentially squirted into the wound during the surgery, and it’s basically a standard analgesic given at the time of surgery that could help to reduce postoperative pain.
If a patient wakes up from surgery with intense pain, and Tylenol is not going to cover it, then they might be prescribed opioids. The hope would be if they get better pain control after the surgery, that might lessen the need to put them on an opioid, and then that would help to stop the problem before it begins.
This one is also in Phase 3 trials, and we’re expecting to see that data in the next few months, probably the spring.
Q: Is the stock riding on this?
Acker: They actually have two other drugs that are currently on the market, and those are for chemo-induced nausea and vomiting, but this would be their largest potential opportunity. We’ve owned the stock for a few years.
Q:On Jan. 29, the health-care industry got a shocker when three major companies— Amazon.com (AMZN), Berkshire Hathaway (BRK.A), and JPMorgan Chase (JPM)—announced that they were planning to form an independent health-care company for their U.S. employees. The decision seems mostly about keeping costs down for their workers, and it’s still unclear how far this compact will go to mimic the role that insurers currently pay and whether drug companies need to worry about their prices. But a number of stocks traded down in reaction. Does news like this alter the way you plan to invest?
Lovell: My initial reaction is that these three companies are telling us that they’re dissatisfied with the level of service and the responsiveness of the counterparties they deal with. That doesn’t mean what they’re attempting to do is going to be simple. There are complexities in the health-care arena that will probably prevent them from having a very dramatic near-term impact.
There are a number of different functions that pharmacy benefit managers and health insurance companies perform. One of them is underwriting risk. That’s not what this three-company compact is about. So what you really get down to is, can the employer go directly to the provider—and I think the answer is yes, to a degree. You have seen some mixed success with that already, where a large employer in a local market contracts directly with the dominant provider of services, and they can effectively gain access and improve the experience of their employees.
But what we haven’t seen is the ability of that employer to manage the expenses they then incur, because one of the things that the health insurer does on behalf of its clients is things like utilization review—do prior authorizations for both pharmaceutical products and for medical services.
Q: What does this three-company compact—and others to come like it—mean for the landscape of health-care investing, particularly in insurance and PBMs, which sound like they could be threatened by this? Should it cause one to invest differently?
Lovell: Fundamentally, it doesn’t change things near term. The insurance companies actually don’t make that much money on the administrative-services side of their business. They make an awful lot more money underwriting small- and mid-size businesses.
Q: In Donald Trump’s recent State of the Union speech, he attacked Big Pharma for high drug prices. Naturally, the shares of big branded companies took a hit the next day. But given that there was no legislative proposal to go along with the rhetoric, how concerned should investors be?
Acker: What we heard out of the president during the State of the Union is very similar to what he said on the campaign trail and in his initial days in office, and we haven’t really seen any material changes.
The approach of this administration and this Congress has been to approach pricing by using competition and by approving more medicines to compete with each other. That’s been the approach of the current Food and Drug Administration. We’ve seen more generic drugs approved, we’ve seen more new branded drugs approved.
The preference is to use market forces to help control drug prices, and we think that has actually been effective, especially in the generic drug market, where pricing has been coming down over the past couple of years.
With Republicans controlling both houses of Congress, I think it’s very unlikely we’re going to see major legislative changes in the near term that would have a big impact on drug prices. Anything we do see is going to have a relatively minor effect.
Lovell: Anything is possible, but I think it’s important to come back to something that remains as true today as it has for years. The pharmaceutical industry, combined, accounts for about 14% of our total spending on health care, a small part of the total. If you’re trying to reduce the amount that we spend, pushing back on branded pharmaceuticals is only going to get you a little bit of juice. There are other elements of health-care spending that are either much larger or much less efficient.
It makes for an easier headline to point to the exorbitant price of pharmaceuticals but, as a practical matter, there are bigger fish that they need to fry.
Q: What are the bigger fish that don’t make for nice political rhetoric?
Lovell: Hospitals are huge employers, and it’s not that hospitals don’t provide valuable services, but there are outlier hospitals that basically charge two or three times what the competitor down the street would charge. Then there’s a tremendous duplication of effort. Not everybody needs to do a chest X-ray, not everybody needs to do their own lab test. So I would point to the much larger amount of money that we spend on physician services, hospital services, clinics, et cetera.
Q: Biotechs are riskier than health care as a whole. If this stock selloff means we’re indeed entering a risk-off environment, will that sentiment drive such stocks down or impact how you construct your portfolio?
Acker: That’s a good question, because we do take that into account. Our approach to health-care investing is to take a balanced approach, with investments across the subsectors within health care. So we have investments in pharmaceutical companies, biotechnology companies, health-care service companies, and medical technology companies.
We tend to have about 30%-40% of the portfolio invested in pharmaceutical companies, 30%-40% in biotechnology, and the remaining roughly 30%-40% in health-care services and medical device companies, with roughly 10%-20% in each of those subsectors. That balance of diversification helps to manage that risk.
Q: Final question: In a December 2016 interview with Barrons.com, Ethan predicted that health-care stocks would be up 20% in 2017. The sector and your fund actually slightly outperformed that number. What’s your prediction for this year?
Lovell: I think it’s actually going to be a fairly healthy climate for health-care investing this year. So I would predict it could be up another 20%, and I’m not just picking that out of thin air. Innovation will be a big part of it, and with the tax reform that we’ve seen, there are going to be a lot of capital projects. So I’m going to stick at 20%. It worked last time, it’s going to work this time.
Q: Thanks, guys