The Life Sciences Report: Bruce, 2015 was a difficult year for investors, but the beginning of 2016 has been quite unpleasant for the global capital markets. This is the fifth year in a row that the S&P/Toronto Stock Exchange (TSX) Composite Index has underperformed the U.S.-based S&P 500. Why the relative weakness in Canadian shares?
Bruce Campbell: The Canadian market is heavily weighted toward natural resources—mining and energy—and, as a result, the perception is that's all there is in Canada. As a result, foreign investors, who tend to represent marginal money that moves in and out, have moved away from Canadian shares. That started about halfway through last year, and it really accelerated into year-end 2015, as foreign investors essentially repatriated that money.
You mentioned we've seen five years in a row of underperformance in Canadian shares, and that certainly is the case. But, there's only been one other period of time since data have been kept on the two indices that we have seen five years of underperformance versus the U.S. We've never seen six years in a row of underperformance by the TSX, and so it is certainly a difficult situation and one that we're living with day-to-day.
TLSR: Investors everywhere tend to be more conservative after a shakeout in the markets. Canadian healthcare shares are more risk-mitigated than many in the U.S., which is home to many startup biotechs, which you don't seem to have in Canada. Could more conservative investors find utility in Canadian healthcare shares?
BC: Certainly. We tend to be a little bit more conservative here. There are companies in Canada that, given a similar type of drug at a similar development stage, would trade on par with their peers in the U.S. They would have market caps of multiples—5 to 10 times—higher in many cases if they were U.S. stocks.
"Nobilis Health Corp. is now getting to levels we think are very attractive."
Looking at the Canadian market, we do have some of those more speculative growth names, but not nearly the number or magnitude of binary-outcome biotech-type stocks you have in the U.S. It's just not to the same degree as what you have in the U.S. That said, the major factor separating the Canadian side from the U.S. is the amount of market cap that some of these companies have.
TLSR: Could healthcare investors find defensive plays in Canada?
BC: There are obviously some pretty interesting stories here in Canada that are generating cash flow and are not facing a binary event, where a drug gets approval or does not get approval. As for more defensive names, you and I have talked in the past about some that are traded on a Canadian exchange but have the majority of their business in the U.S., such as Nobilis Health Corp. (HLTH:NYSE; NHC:TSX). In a lot of cases this model is fairly repeatable, and it's not at all like trying to find that needle in the haystack. That said, some companies in Canada have been hit pretty hard in the last year.
TLSR: You manage a hedge fund, the StoneCastle Fund, and two regular mutual funds. One of your associates sent out an email noting that 51% of the assets in both your Redwood Income Growth and your Redwood Equity Growth mutual funds were in cash. It seems very unusual that you have flexibility like that in a regular mutual fund. Most regular mutual funds in the U.S. stay fully invested. Are you able to transition to such a large percentage in cash because you keep these mutual funds small?
BC: When we established those funds with Redwood, we actually set them up so we'd have maximum flexibility across the board. While it's an equity growth or an income growth portfolio, which most people would assume have a fully invested portfolio of stock, we could be in U.S. stocks, we could be in Canadian stocks, we could be in cash, or we could be in fixed income. The charter gives us the ability to grow everywhere.
"Cipher Pharmaceuticals Inc. does have cash flow, and it has been growing; compared to its peers, it's trading in a fairly reasonable range."
We will keep these funds small because we think flexibility is very important to what we want to do. In Canada, you frequently see fund managers do extremely well, and that garners a lot of assets, which handcuffs the managers. They either have to change their investment style, or they have to dilute their performance. You often see returns get really watered down. That's one thing that we're cognizant of, and it's something that we want to make sure is not an issue for us.
TLSR: One thing they can't do when they garner so many assets after a successful run is continue to own small market valuation companies. They have to migrate up the food chain. Do you see that too?
BC: Yes. In the Canadian market, there tends to be a fairly high return profile for what we consider to be our mid-cap market—what you in the U.S. would consider to be your small-cap market—that sub-$2 billion range. There are lots of opportunities in Canada, and there are lots of fund managers who have been really successful investing in that area. They bring in all this money and then they either have to hold small percentage positions of the small-cap names in their fund, which won't really make a difference in returns, or they just abandon that idea altogether and go to larger-cap names.
TLSR: A recent communication from your firm indicates your three favorite picks are a company that sells insurance and financial services, a utilities company, and an operator and licensor of convenience stores. Does that imply you are underweighting life sciences or healthcare currently?
BC: We are right now, yes. I mentioned those three picks on the Canadian business channel, Business News Network (BNN). It has a phone-in show where people ask you questions about stocks. At the end of the show, they ask you for your three top picks. I named Algonquin Power and Utilities Corp. (AQN:TSX), Alimentation Couche-Tard Inc. (ATD.B:TSX) and Fairfax Financial Holdings Ltd. (FFH:TSX).
"There are companies in Canada that, given a similar drug at a similar development stage, would trade on par with peers in the U.S."
Those choices are a function of the markets and the fact that we are in defensive mode right now. We are sitting there with 50% cash because we want to be conservative. We see incredible value in some healthcare/life science names, but we're also looking at it from a perspective of whether they have bottomed and at what point should we step into them.
TLSR: Let's talk about some of these names, please.
BC: I mentioned Nobilis Health already. We don't currently own it, but we have owned it in the past and are certainly keeping our eye on it. Nobilis is now getting to levels we think are very attractive—just under CA$3/share range. It hit CA$11/share briefly last April. The company recently reaffirmed its guidance, and it gave a wider range than it had before, but even at the bottom end of that range, the stock certainly has tremendous value.
A little recent background is in order here: Nobilis has had a very interesting year, and it had been executing and doing everything it told us it would. Then, in October, there was a Seeking Alpha article by an anonymous writer who basically laid out his short position strategy for the stock, and that took it down about 40–50% over the next couple of days and weeks. Since then, Nobilis has had some other bad-luck or bad-timing events. It changed its auditors, and its quarterly filing was delayed a couple of months while the new auditor went through everything with a fine-toothed comb to make sure all the numbers had been categorized correctly. In the meantime, uncertainty dragged the entire market down, and Nobilis shares went down with it. We don't own it right now, but it ranks fairly well in our process.
TLSR: How does a company with an acquisition strategy like Nobilis fare in a market like this, where it does not have the share-value currency it had one year ago?
BC: When a company's stock price goes from where it was a year ago to where it is today, that makes it more difficult to go out and make a significantly large, transformational transaction, but it doesn't make it impossible. Of course, even beyond the straight dollars in its pocket, a company would choose, if it could, to have a higher stock price, because that would make an acquisition easier due to its share-price currency, and also because it would have better access to capital markets.
"The major factor separating the Canadian side from the U.S. is the amount of market cap that some of these companies have."
In this case, Nobilis has a fairly clean balance sheet with just a little bit of debt. So it could look at taking on a manageable amount of debt to pull off an important transaction. Then, when the stock price hopefully appreciates based on company fundamentals, Nobilis could either raise equity to pay down that debt or just use cash flow to pay it down. If a company chooses to leave the debt there on the balance sheet, then maybe it does an equity transaction down the road to make more acquisitions.
TLSR: The Patient Protection and Affordable Care Act (ACA) has added 19 million new insured patients in the U.S. since it went into effect in 2010. We are about 10 months away from a general election here in the U.S., and as you know, every single Republican running for president has vowed to dismantle the ACA if elected. Would it hurt Nobilis if a Republican is elected?
BC: That would be a risk for Nobilis because it would impact its business. It's a risk that we have to take a look at and try to handicap as we look to November.
TLSR: What is your next name?
BC: Cipher Pharmaceuticals Inc. (CPHR:NASDAQ; CPH:TSX) is a company that we don't currently own, but it is a specialty pharmaceutical, and its specialty niche is dermatology. Cipher, too, has had a tough year, and that's a function of the market trying to figure out where its growth will come from and what its strategy is.
Part of the problem is as the share price goes down, it becomes a self-fulfilling prophecy, because investors become concerned that the company would have a tougher time using its shares as currency to make an acquisition. Cipher does have cash flow, and it has been growing. That's a positive, and it's something we are certainly interested in, especially given where the stock is now compared to where it has been. When you look at the valuation here, compared to its peers, it's trading in a fairly reasonable range, less than 10 times enterprise value:EBITDA (earnings before interest, taxes, depreciation and amortization). A lot of its comparables are at 10–11 times. We have Cipher on our radar screen.
TLSR: Cipher still has a market valuation of about CA$139 million (CA$139M). It has been taken down about 70% from a year ago. But over the past 12 weeks, a very painful time in global stock markets, Cipher is actually up 4% in Canadian dollars and down only 2% in U.S. dollars. This stock has relative strength against a very weak market. Is there a reason for that? Is it just oversold?
BC: I think it's gotten down to a valuation level and oversold enough that people are digging around, looking. In the Canadian markets, up until Dec. 23, we were seeing tax-loss selling continue to come in. Cipher was down on the year. Rolling into the new year, we started to see some of that wane, and the stock had a bit of a move from the middle of December right to the end of the year. Then it basically stuck in pretty well this year, during a time when a lot of its peers have been beaten up.
TLSR: Another name you might mention?
BC: CRH Medical Corp. (CRH:TSX) is very similar to Nobilis in that its business is primarily focused in the U.S., but it's a Canadian company, actually a little more so than Nobilis. It does have some business in Canada, but it made a transformational acquisition a little over a year ago and has gotten into a new area that's an offshoot of what it was doing before.
"There are some pretty interesting stories here in Canada that are generating cash flow and are not facing a binary event."
CRH had a hemorrhoid treatment called the O'Regan System, and it made a transformational acquisition getting into anesthesiology, specifically for gastroenterologists doing colonoscopies. Then, during the year, the company made a number of smaller acquisitions. CRH's share price has been hurt, but if this were an industrial company with these same numbers, it probably would not have sold off the way it did. It has been dragged down, and now it's another name trading at a very attractive valuation.
TLSR: Bruce, I'm noting that CRH made another small anesthesiology practice management group acquisition on Jan. 4. It doesn't seem to be slowing down, even in this very tough stock market environment, and it didn't use stock; it used cash on hand. That's interesting in this market, don't you think?
BC: The company has good cash flow, and it will probably continue making smaller acquisitions, rolling up little companies. At some point when its stock price moves higher, it will probably look at executing a larger transaction that would move the needle more, as opposed to just small buys that give the company incremental growth.
TLSR: Another name?
BC: Merus Labs Inc. (MSLI:NASDAQ;MSL:TSX) falls into a very similar category as Cipher and something like Acorda Therapeutics Inc. (ACOR:NASDAQ), another specialty drug company. Merus had a lot of uncertainty over the last year because it has a product, one of its drugs in Germany, that was coming up for pricing review. There was a lot of uncertainty over how that product would get repriced and what it would get from that. Of course, once that settled down in the fall, the stock started to make a bit of a move up and recover some of the ground it had lost.
TLSR: Just looking at Merus' performance, it's down 7% Canadian from one year ago, which for practical purposes is really kind of flat, considering the volatility of this market. Again, good relative strength, no?
BC: It's been a roller-coaster ride the whole way, but Merus does have a really solid balance sheet, and it certainly has growth ahead of it. It can probably make some acquisitions that won't move the needle for a lot of larger companies, but it could be important to Merus because of its size and because of its balance sheet. Small acquisitions will definitely impact its business.
TLSR: Merus has put together a portfolio of very old generic products and put them in new packaging. How is it able to make margins on these older molecules?
BC: Part of this business model has to do with its cost to operate. Merus has a pretty lean team as far as its sales go. I don't imagine that most of its sales staff is out talking about these older products because these are drugs that would be known to physicians. It's also probably a function of where it bought these drugs, what it has paid for them, and what it has as far as costs go, to be able to continue to market and sell these drugs when it is not getting the premium pricing that it would from a new drug.
TLSR: Another name?
BC: Patient Home Monitoring Corp. (PHM:TSX.V) has a very interesting business. It's all U.S.-based, and the company made a number of acquisitions in the last year. It also has some businesses that are growing at fairly substantial rates. If most bigger companies could have growth rates like that, we'd be astonished. We're talking a 25–34% compounded annual growth rate.
Again, Patient Home Monitoring has gotten beaten up a bit by the market, and it now trades at what would be considered fairly cheap valuations. It's probably trading at less than five times earnings, and that's really a function of where it trades—on the TSX Venture—and also the management team.
TLSR: Why is Patient Home Monitoring trading at such a low multiple? You mentioned the management team. What did you mean?
BC: It had a management team in place halfway through the year, then the company made a transformational acquisition and handed over the reins to the operators of the business it had just bought. That was its biggest transaction, and the new operators took the majority of their compensation in shares of the stock at a price that was almost $1 higher than where it is now. The previous management team handed the ball off, but did a really poor job of announcing what its intentions were and how the transition was being done, and the market was uneasy at the time. Basically, traders just took the stock out and shot it. I think a lot of the institutional investors are now out of this name, and it has basically been left in the hands of retail investors.
TLSR: That sounds like a very negative assessment. Is there a reason investors should look at this name?
BC: The good news is that Patient Home Monitoring has no debt. It has cash on the balance sheet, and it has said that it could do more acquisitions if it wants to, but right now it is focusing organically on its business. And that's really what it's been doing.
TLSR: Bruce, in 2015 revenues were up 87%, while cash flows—EBITDA in this case—were actually up 144% from fiscal 2014. Is there a single driver, or are there a lot of products growing like this?
BC: I think there are a lot of products growing, but it's concentrated in a couple of areas. When Patient Home Monitoring was originally making its acquisitions, it was all over the place. It was making everything from monitoring to mobility aids and everything in between. Its big acquisition was a company called Sleep Management, which deals with the whole sleep apnea area. That was a business that was growing at about 100% per year over the last three years—before Patient Home Monitoring bought it—and it's the company's largest business unit. The operators of Sleep Management are the ones who took over management, and I think that's where the focus is now. The company is going to expand the sleep apnea business out across the country. The new managers took over in the summer, and they have generated strong numbers, but, of course, everyone is looking for what they are going to do next. Investors want to know when and where the real sizzle is going to come from, as opposed to ho hum, we just grew our business by 25% in the last year.
TLSR: A bit ago we were talking about the upcoming U.S. election. A couple of the candidates have been talking about an opiate addiction surge in New Hampshire and other U.S. states and cities. You have spoken to me in the past about companies involved in addiction. Are you still invested in that category?
BC: Yes, we own some Convalo Health International Corp. (CXV:TSX.V). We actually own two companies that fall into that general category. Convalo is in the drug rehab area, and it is one that has been growing. It was under the same management team as Patient Home Monitoring. Everyone thought that management was going to do the same type of acquisition strategy as Patient Home Monitoring and acquire a whole bunch of rehabilitation clinics. Convalo actually found it's cheaper to build them than to buy them, but that takes longer to do.
"In the Canadian market, there tends to be a fairly high return profile for what we consider to be our mid-cap market."
From all accounts, Convalo's business is growing really well and, as you said, this is a real hot button issue right now. There are so many people abusing painkillers and getting addicted to them. Convalo has stepped in and is trying to build a niche under the radar of the bigger operators. So far, it has a couple of locations in Los Angeles, and it is working on a location for San Francisco. I think its plan is to have about nine different locations in the U.S. Then it will be a cash flow machine. Just look at the numbers it's generating now. It has great cash flow going to the bottom line.
TLSR: You said you own two companies in the addiction category. What's the other one?
BC: It's a specialty pharma model called Intellipharmaceutics International Inc. (IPCI:NASDAQ). The company has a tamper-resistant formula for OxyContin (oxycodone), and right now it's going through all the stages to try to get it approved as a generic, but it has some qualities that some of the other tamper-resistant products do not have. This is interesting because it is going to be incredibly difficult to do any studies on. The product is one where you can take 10 of these pills, but you still only get dosed to the level of one pill.
TLSR: I can see why clinical studies would be difficult. You're not going to give human patients 10 pills to see if it works like it's supposed to, are you?
BC: No, you are certainly not. It's hard to do a double-blind study on something like that where you're going to load somebody up with a potentially toxic dose, but I've spoken to analysts who have looked at this, and it could be an amazing application of this technology.
TLSR: Thank you, Bruce, for your insights.
Bruce Campbell is founder and portfolio manager of StoneCastle Investment Management Inc., and he is former portfolio manager for some of the largest investment dealers in Canada and the U.S. Campbell brings more than 22 years of experience to fund management. He is a graduate of the University of Alberta with a bachelor of commerce degree specializing in finance, and he has earned multiple designations in investment management, including the Chartered Alternative Investment Analyst (CAIA) and the Chartered Financial Analyst (CFA) designation, one of the most prestigious designations in the financial industry. Campbell is a past president of the Okanagan CFA society.
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DISCLOSURE:
1) Dr. George S. Mack conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report and The Life Sciences Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of Streetwise Reports: Nobilis Health Corp. and Cipher Pharmaceuticals Inc. The companies mentioned in this interview were not involved in any aspect of the interview preparation or post-interview editing so the expert could speak independently about the sector. Streetwise Reports does not accept stock in exchange for its services.
3) Bruce Campbell: I own, or my family owns, shares of the following companies mentioned in this interview: None. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Redwood Asset Management. Funds controlled by StoneCastle Investment Management holds shares of the following companies mentioned in this interview: Convalo Health International Corp. Algonquin Power and Utilities Corp., Alimentation Couche-Tard Inc. and Fairfax Financial Holdings Ltd. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I determined and had final say over which companies would be included in the interview based on my research, understanding of the sector and interview theme. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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