Economic conditions boding well for an above trend rebound in 4th quarter

The Federal Open Market Committee (FOMC) minutes and statement, alongside a couple of noteworthy economic data releases were this month’s focus: The consumer price index (CPI) increased in September, mostly following higher energy prices. Core CPI rose less than anticipated, with its year-on-year rate remaining stable around +1.7%. On the industrial side, production saw a rebound in September. As expected, the output levels are however still below trend due to continued hurricane-related disruptions, boding well for the Investment Adviser and an above trend rebound in Q4.

Monthly Fund Commentary
30 Nov 2017

The Federal Open Market Committee (FOMC) minutes and statement, alongside a couple of noteworthy economic data releases were this month’s focus: The consumer price index (CPI) increased in September, mostly following higher energy prices. Core CPI rose less than anticipated, with its year-on-year rate remaining stable around +1.7%. On the industrial side, production saw a rebound in September. As expected, the output levels are however still below trend due to continued hurricane-related disruptions, boding well for the Investment Adviser and an above trend rebound in Q4.

The Q3 advanced real GDP estimate rose by 3%, above the expected 2.6%. Both, inventories and net trade were positive but, taking into account the impact of natural disasters on consumer spending and the housing market, the 1.8% quarterly growth in domestic demand was notably firm.

The Fed Fund’s target range remained unaltered at the Fed’s November meeting. The only noteworthy change was the upgrade of the growth assessment to “solid” for the first time since 2015. The Investment Adviser perceives this to be consistent with a December rate hike, as long as economic conditions don’t take a turn for the worse. Additionally, the minutes from the September FOMC meeting discussed the short-term effects of the recent natural disasters. The views remained broadly unchanged with regard to the growth rate and inflation outlook. Inflation is still broadly expected to pick up as a result of cyclical pressures, with 12 out of 16 participants foreseeing a third rate hike this year.

In October, the Fund returned +1.38%, compared to a benchmark return of +2.26%. The Fund’s relative underweight in both, telecommunication and energy sectors were tailwinds, whilst the overweight in Healthcare served as a headwind. Stock selections in Quintiles and Marriott boded well in October and added +0.41% and +0.20% respectively. On the other hand, Celgene and Allergan both continued to face pressure, resulting in a decrease in performance of -0.74% and -0.37% respectively.

20 companies held by the Fund reported their Q3 earnings in October with a surprising average EPS growth of 4.5%. Quintiles IMS published their results on 26th October. The data was positively surprising on both bottom and top lines, indicating a pristine yearon- year EPS growth of 19% and a 78% year-on-year growth in sales. The EPS beat was attributed to both, strong organic (constant currency) top-line growth in Research and Development (+6.9%) and commercial solutions (+2.9%). The Company also managed to improve its operating efficiency, as the gross margin expanded 91bps sequentially, while the adjusted EBIT margin increased by 70bps.

Celgene and Allergan (the two largest monthly detractors) both reported their earnings with better than expected EPS results, however at the same time missing out on revenue. Recently, large capitalisation biotech companies have been under pressure due to (1) pricing pressures (usually pricing negotiations with Pharmacy Benefit Managers (PBMs) begin during the summer for the following year and the environment for such hasn’t been ideal, contemplating the noise generated in the news), (2) clinical disappointments (these seem to carry more weight as companies with patent cliffs need to replace strong revenue flows), and (3) M&A and drug erosion from generic entries.

In light of these developments, the Investment Adviser however still thinks that Allergan’s current stock price reflects an overreaction to Restatis’ entry into the generic drug market in 2018 and the resulting competition. The team believes that the shares are considerably undervalued given the aesthetics business, new products, and the pipeline to sustain future growth opportunities.

A similar opinion is in place for Celgene, even though this case is slightly more complicated. After disappointing results for the Otezla drug (psoriasis/psoriatic arthritis), management lowered their 2020 guidance, incorporating the continued weakness of Otezla alongside lower expectations for the cancer drug Abraxane, the removal of Crohn’s disease pipeline drug (GED-0301), and a later launch date (due to slower trial enrolment) for Ozanimod in ulcerative colitis. Therefore, the core focus of the market now primarily lies on the 2020 guidance.

Nonetheless, the Investment Adviser still expects returns on invested capital over the next five years and believes that the stock price reaction is exaggerated. Celgene’s renewed guidance for 2020 assumes a 14.5% CAGR, as well as around 20% (non-GAAP) EPS growth, which still compares favourably to peers. Additionally, the company’s goal of growing through the expiration of Revlimid’s patent now appears to be more of a challenge (Revlimid still accounts for roughly two-thirds of Celgene’s revenue) and will put more pressure on the Company’s drug pipeline when Revlimid generics will be launched. Nonetheless, the Investment Adviser believes that Revlimid sales projections have the potential to surprise on the upside and notes that Teva is the only generic drug in the foreseeable future, leading to a potentially more subdued decline in U.S. branded Revlimid sales.

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The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 14/11/2017 and are based on internal research and modelling.