We often show investors our sector and region weights. These are important aspects of our portfolio construction process because ensuring a wide spread of sector and country exposure is a sensible way to diversify and control exposure to a detrimental event in any one country or sector. The sector definitions make intuitive sense, as do the regions or countries into which the companies are placed, but companies are often classified as one type of company when they are really another. Understanding what drives a company’s profitability, and where the risks lie, is important and to that extent it is important to not just passively accept the classifications given to you by convention.
This is why a sophisticated risk model is critical since many companies classified as one type of business actually contain elements of others. Put together in a portfolio these elements can combine to produce large unintended and undesirable characteristics. Portfolio management is more than picking stocks one by one – you have to know where the aggregated risks are and how big and how to measure them.
A current example of a technology stock which perhaps isn’t, would perhaps be Apple, which is increasingly a consumer goods company? Most of its manufacturing is outsourced although it designs the items and operating system; it relies heavily on constant fashion cycles to drive revenues; and it sells directly to the consumer from its own branded stores. If it were a French luxury goods company such as LVMH or Hermes, would it be treated and rated differently by the stock market? Quite probably. Similarly, Google, while definitely still a tech stock, could also be considered one of the world’s premier advertising companies.
A technological advantage is worthwhile because it protects margins and the business franchise. One of our investment themes is that technology is increasingly to be found everywhere and as a key source of competitive advantage, is not just in semiconductors or circuits, but also in supply chain logistics, or heavy equipment manufacturing, and resource exploration and extraction. As technology enters more industries we ask why do tech stocks (hardware and software), command a premium P/E multiple?
Technology can fail and be subject to intense competition and regulation. Furthermore the capital investment required by technology companies to stay ahead, can be enormous and single failed product cycles disastrous. Nokia used to be THE dominant mobile handset company but missed a couple of product cycles and is now an ‘also ran’. Before then came Sony which really should have invented the iPod or generic digital portable player, since it had been first with The Walkman. For whatever reason it became side tracked and missed the shift to digital. The list goes on. Companies with such requirements to keep spending exposure should arguably trade at a P/E discount to reflect this risk?
Consequently if you can invest in technology without the high P/E then why wouldn’t you? Such opportunities exist and they exist outside the sector classified as “technology”. Our favourite example would perhaps be Gilead, the bio technology company. This is now our largest holding after a decent rally in the last few months.
Following the Kite acquisition we have looked at what the acquired cancer technology does and it is pretty astounding. Just as clever as placing binary code on a graphics chip and sound card to make a mobile phone – or at least we think so.
Kite, now owned by Gilead, specialises in oncology or cancer treatments. They have produced a new way to fight certain types of aggressive cancers by reprogramming the body’s own auto immune system. CAR-T or Chimeric Antigen Receptors are programmed onto T cells which are taken from the blood of the patient. T cells do the fighting against foreign cells for the body. These receptors are programmed to fight the specific cancer and are consequently a much less traumatic process then radiation, surgery, or chemotherapy which are the other options.
The best analogy we can think of is the training of special police forces to drop into a crowd riot and identify and take away the key agitators. Up until now, the only option has been to isolate and contain the whole crowd and be prepared to arrest everybody and anybody.
Adding to the complexity is the fact that the blood has to be reprogrammed in a laboratory and then taken back to the patient. This has to be done quickly since these cancers are often aggressive. Think of this as supermarkets running logistics to get fresh food from the farm to your table in a few hours or days. And yet supermarket multiples are higher than GILD which trades on a P/E of less than 12x.
CAR-T is applicable in other areas than oncology so Gilead have potentially bought a complete drug delivery system. Currently it is dealing with blood and potentially lymphoma cancers, but tumours in pancreas or liver or auto immune diseases like type 1 diabetes or lupus are potentially treatable and curable with this CAR-T approach.
For all those ESG investors out there it also does some real good since it actually cures people, it isn’t just a treatment. Hence the shrinking market for some of Gilead’s original drugs which cured Hepatitis C.
For certain there are risks, as with any investment. Gilead needs to grow its other drug treatments offshore and incidentally has just won approval in China for its Hepatitis C drug. Additionally, Gilead and Kite won’t be the only pharmaceutical company developing this treatment, and Novartis, a Swiss based company, is already out there with an approved product, but it trades on a multiple of 30x. There will also be an issue with the cost of CAR-T, since treatment is expected to be c.$500k for a one time attempt.
However, we think that buying cutting edge technology on a P/E of 11x is a pretty good price and notwithstanding the challenges with its existing drug pipeline, as well as obtaining US government approval for this therapy, GILD looks to be up with Novartis and ahead of the crowd, and as worthy as Facebook, Apple, and Amazon as being considered a technology leader: at a fraction of the valuation.
