AMM Dividend Letter Issue 13: Winning the Loser’s Game with Novartis (NVS)
This is from the AMM Dividend Letter released November 8, 2014. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
There are two types of tennis games. The game professionals play, a winner’s game, and the game Glenn plays with his friends on the weekend, a loser’s game.
Professionals playing a winner’s game have to win their points. A professional player’s opponent is equally as talented and shots need to be placed out of their opponent’s reach to win. When amateurs play tennis they are playing a loser’s game. Amateur tennis players are prone to double faulting, hitting the ball into the net, or hitting the ball out of bounds. Winning a point in a loser’s game is all about keeping the ball live and giving your opponent enough time to make the mistake.
- Other loser’s games:
- Golf – whoever makes the least mistakes usually wins
- Politics – it’s about making voters not vote for your opponent rather than making people vote for you.
- War – The side that makes the least amount of tactical and strategic errors usually wins.
- The Stock Market
Investing in the stock market like a lot of things started out as a winner’s game. There was a time when a very smart, ambitious, and aggressive investor could win points against the rest of the crowd through many market inefficiencies. Now there are a lot of very smart, ambitious, and aggressive people working in the investment business competing away those inefficiencies. The stock market has shifted from a winner’s game to a loser’s game.
This is not to say you can’t win at investing; it means the strategy to succeed has shifted. The strategy is now like an amateur tennis game, reduce the unforced errors.
Reducing Unforced Errors in Investing
Charles Ellis in his essay The Loser’s Game highlights the strategy shift and the approach we take to daily portfolio management.
1) Reduce portfolio turnover. The highly liquid nature of the stock market may look like an asset but it can be a huge liability. It is far too tempting and easy given the immediate liquidity to sell stocks when things look scary. On top of the extra drag from increased commissions and fees, selling creates another problem, when to buy back in? Instead of having to make one right decision, selling, you have to make two correct decisions, selling and buying. The 15 year performance study of 81 “professional” stock-market timers by Hulbert Financial Digest shows this is an extremely difficult task.
Just 11 of 81 stock-market timers—those advisers who try to predict when to get into or out of the market to sidestep declines and participate in rallies—actually made money during the bear market that began after the Internet bubble burst in March 2000 and ended in October 2002.
These market timers have lost so much since then that, on average, they are in the red over the entire period since March 2000, having chalked up a 0.8% annualized loss.
2) Keep it simple. From the book Extraordinary Tennis Ordinary Players by Simon Ramo, “Every game boils down to doing the things you do best, and doing them over and over again”. We’re focused on buying high-quality, highly profitable, and high cash flow generating businesses that pay a dividend and grow their dividend at a compound annual rate far above the rate of inflation.
3) Avoiding portfolio pitfalls. Most investors focus on what to buy and most research out there is designed to help them do just that. However, more time should be spent on what to sell. The biggest risk to a portfolio is already in there. Eliminating future problems provides far more benefits in the long run then not buying a specific stock.
Following this strategy does not mean we will not make errors, we will. Errors are unavoidable. Reducing and avoiding errors as much as possible leaves behind a series of small portfolio successes. These small successes compounded over time lead to long-term portfolio gains.
Dividend Stock in Focus
Novartis AG (NVS): $91.76*
*price as of the close November 7, 2014
Novartis is a Switzerland based diversified pharmaceutical company. It operates in branded pharmaceuticals, generic pharmaceuticals (Sandoz division), eye-care (Alcon division), consumer health, and vaccines. The overwhelming majority of Novartis’ revenue and profits, 55% and 85% respectively, comes from its branded pharmaceuticals. Novartis’ revenue sources are broken down further in the chart below.
Because branded pharmaceuticals drive so much of Novartis’ revenue and profits we will highlight two of their drugs below. The first drug is one of Novartis’ top late stage drugs that will drive near term revenues and profitability. The other is an option on the future and a potential breakthrough in cancer treatment.
Over the last 9 years Novartis has grown its dividend at a compound annual rate of 11.77%.
Catalysts for Dividend Growth and Price Appreciation:
Heart Failure & LCZ696
Heart failure is essentially the inability of the heart to pump an adequate amount of blood to meet the demands of all the body’s organ systems. Heart failure is the end stage of a culmination of several cardiac diseases like chronic hypertension, coronary artery disease, cardiomyopathy (damage to heart muscle), and other diseases like diabetes and emphysema. A large problem with heart failure is the lack of blood flow causes the kidneys to turn on a hormone system known as RAAS (Renin-Angiotensin-Aldosterone System). The RAAS system tells the body to hold onto sodium and water in an effort to increase blood flow but this is not a good thing during heart failure. The excess blood volume causes the heart to pump less well.
The standard treatment for heart failure is counteracting the RAAS hormone system with either Angiotensin-Converting Enzyme Inhibitors (ACEIs) or Angiotensin Receptor Blockers (ARBs). The use of either two has shown to reduce heart failure mortality by 16%.
The body during heart failure actually releases natriuretic peptides that tell the kidneys to stop holding on to water and salt through the RAAS system. The problem is the Neprilysin enzyme. During heart failure there is so much of this enzyme floating around that it shuts down the natriuretic peptides. In theory a novel drug that did the same work as the Angiotensin-Converting Enzyme Inhibitors (ACEIs) or Agiotensin Receptor Blockers (ARBs) and blocked the effects of Neprilysin would reduce heart failure mortality rates even more.
Enter Novartis’ LCZ696.
The charts below are from a recent study comparing the effectiveness of LCZ696 (redline) versus Enalapril (black line), an Angiotensin-Converting Enzyme Inhibitor, for patients with systolic heart failure (left side of the heart can’t pump blood effectively).
Essentially the study shows that LCZ696 is significantly more effective in reducing the risk of death and hospitalization from heart failure than the current method of using an ACEI by itself. The study doesn’t argue for an add-on of LCZ696 to the current method for treating heart failure, it can’t because of the risks of other complications. Rather the study supports the argument that LCZ696 should replace ACEIs and ARBs.
LCZ696 can’t replace ACEIs and ARBS completely because of physician resistance and some patients’ inability to tolerate the medicine. However, given the current prevalence of heart failure in the U.S. and expected U.S. and global growth this creates a huge market opportunity for Novartis and LCZ696 in replacing ACEIs and ARBs.
In the most recent earnings call management said they see sales in the $2-5 billion range while analysts are predicting sales in the $8-10 billion range. Management tends to under promise and analysts tend to be too optimistic. The real range probably lies in the $5-8 billion range.
Novartis is expecting to submit LCZ696 to the FDA by year-end and obtain a decision by the end of 2015.
Car T Cell therapy
22 children with acute lymphoblastic leukemia, the most common childhood cancer, were out of luck. They had exhausted all current drug treatments and bone-marrow transplant options. Their very last option was to sign up for the experimental trial of Novartis’ latest cancer treatment.
90% of them saw their leukemia enter into remission.
The treatment is called CAR T-Cell therapy. It is the body using its own immune system to detect cancer cells and destroy them in a highly targeted attack.
The market potential for this new type of therapy has been estimated as high as $35 billion and upwards of $10 billion in sales per year for Novartis’ leukemia treatment CTL019 (CART-19) alone.
With high rewards come high risks. Right now the therapy isn’t easy to produce and even harder to mass produce a personalized cell-based treatment. A mistake in the “reprogramming” of the T-cells and their reintroduction into the patient’s body can lead to a deadly side affect, cytokine release syndrome or more ominously known as a Cytokine Storm. Then there is always competition from other pharmaceutical companies. If the efficacy from this first small trial holds up in upcoming larger trials and if Novartis can overcome the manufacturing hurdles then the market potential for these new cancer treatments is huge.
Our investment in Novartis is not dependent on the success of CAR T-Cell therapy. We believe we are buying a very cheap call option on the market potential of CAR T-Cell therapy wrapped around a large diversified pharmaceutical company.
Lateg Stage Pipeline Can’t Replace the Patent Cliff
Each and every large pharmaceutical company is facing a loss of patents on many of their top selling drugs, Novartis is no different. However, Novartis’ late stage drug pipeline is considered to be one of the best, relative to other large pharmaceutical companies. LCZ696 is one of the late stage drugs that makes Novartis’ late stage pipeline so attractive. However, no matter how attractive their pipeline these drugs are not blockbusters yet nor have they even been approved by the FDA.
Diovan Patent Loss
Diovan is an Angiotensin Receptor Blocker (ARB) mentioned above and it also accounts for about 10% of Novartis’ total sales. Diovan is a part of the “patent cliff” facing Novartis; the drug came off patent in 2013. Generic competition will take market share away from Novartis and eat away at Novartis’ sales. This is why LCZ696 is crucial to Novartis growing future sales.
Efficacy & Cost Effectiveness
The blockbuster status of LCZ696 will come down to a couple questions. Is the drug truly more effective than current heart failure treatment? The most recent data says yes but again this was a done in part by Novartis. If further data shows otherwise then future sales of LCZ696 will be affected.
The second question is what is the correct pricing for the drug to get maximum conversion for heart failure treatment while still garnering a premium price? If the drug is priced too high above generic ACEIs and ARBs, even given the higher efficacy of LCZ696, Novartis may hurt the adoption rate and sales of LCZ696.
Novartis has been a holding in portfolios since late 2011. We have held off on making any new purchases for newer accounts as the stock consistently traded above our estimate of fair value, albeit by a small margin. So why did we finally make a new purchase after the company hit another new high? Our valuation changed with the release of LCZ696’s latest data. Novartis’ late stage pipeline became more valuable and we adjusted our estimate of fair value upward to $100 per share. In hindsight, as you can see in the chart below, if we had waited a few weeks we would’ve had a much better opportunity to buy Novartis. We can’t control the future. We can only focus on our valuations and our process and based on both Novartis became a buy again.
Price is what you pay and value is what you get. – Warren Buffett