Tuesday, April 22, 2014

Michael Castor on Investing in Healthcare

Over the weekend, Dr. Michael Castor, Founder and Managing Portfolio Manager of SIO Capital Management, shared his thoughts with me on investing in healthcare (added emphasis is mine):
Persons interested in allocating/investing their assets tend to have two different schools of thought regarding investing in healthcare. The first line of thinking, which seems to be more common, is that healthcare is a great area in which to invest because there exist: (1) unmet medical needs yet to be addressed, (2) amazing scientific technologies that were not in existence just a few years ago, and (3) an aging demographic globally and commensurately an increasingly large pool of consumers of healthcare goods and services.

All of these are true, but they fail to recognize other truths that are equally important. First, there has been a trend toward aging demographics for decades. Second, while technologies are better, the hurdles for discovering new drugs and therapies are much higher. Over the past few decades, there have been incredible, life-saving discoveries including drugs to lower blood pressure, drugs to treat high cholesterol, drugs to treat various cancers, artificial joints and heart valves, pace makers, and diagnostic tools such as MRIs and PET scanners. Arguably, these were low hanging fruit, but they have made enormous impacts on health and longevity. Incremental discoveries that will provide further benefits become increasingly challenging to find.

Further, economic pressures augur against sustained growth in healthcare. At present, healthcare currently consumes over 17% of U.S. GDP, up from about 7% in 1970 (sources: The World Bank; CMS; CMS again). At such a level, there is a need for payers, whether they be governments or private companies, or insurers, to push back against further growth. It is likely not economically bearable. As a result, healthcare becomes a zero-sum game constrained to GDP growth rates (meaning that increases in spending in one area must be offset by decreases in other areas). Part of the growth in spending over past decades has arisen because of the complex nature of delivery of healthcare. There are inefficiencies in the market and information failures. The involved parties (payers, decision makers, and users/patients) all have different agendas, different pressures, and different levels of information. I have written about the economics of healthcare delivery on my blog (see: The problems inherent to healthcare economics and Healthcare economics – Medical billing: an arcane, problematic system and More on generic Viagra: inefficiency within healthcare).

Since the mid 1990s, price increases have been meaningful drivers of the growth in healthcare (here are some things I’ve written on my blog about drug prices: Should prescription drugs cost as much as they do? and Drug price inflation). Specifically on that point, the launch of a single new hepatitis drug (called Sovladi) has triggered a cascade of scrutiny about the high prices of certain drugs. Similarly, the American Society of Clinical Oncology (the leading medical group that focuses on treating cancer) is reportedly discussing an initiative to encourage doctors to consider the prices of medications as they decide on treatment regiments. Stories such as these are also garnering attention in the media, such as in the recent New York Times article Cost of Treatment May Influence Doctors.

I favor a second line of thinking about investing in healthcare, namely that this sector is highly specialized, complex, and esoteric. This complexity and specialization leads to mispricing of stocks and opportunities to invest in individual, specifically-selected equities (as opposed to seeking indiscriminate exposure to the healthcare universe broadly). The complexities are multifold, with scientific issues, regulatory dynamics, political machinations, and intellectual property matters variably influencing individual companies. These exist on top of the already arcane delivery of healthcare and the complex business operations of the companies involved. Any or all of these issues can drive mispricing of stocks. Indeed, even if one takes the view that secular trends will drive growth in healthcare, such an outlook might already be reflected in stock prices. Moreover, investors can become overly optimistic and bid prices up to inappropriately high levels. Behavioral biases exist for healthcare stocks, with exuberance and fear driving prices and creating opportunities.

On the topic of exuberance, healthcare can generate excitement for scientific reasons (the promise of curing cancer or any number of reasons) and economic reasons (the prospect of investing in a growth area not leveraged to the economy when investors become concerned about recessions or economic slowdowns). Markets become frothy at times. Wall Street analysts find reasons to justify higher stock prices (such as lowering their discount rates for future earnings or ascribing higher probabilities of success to early-stage, speculative drugs or unproven business models). These types of scenarios are not infrequent. As a result, there are excellent opportunities to find ‘short’ investments in healthcare, not just long investments. Catalysts for individual ‘short’ investments can run the gamut from disappointing earnings to the emergence of competition to failed clinical trials to decelerating revenues. Further, holding individual short investments that are intended to generate alpha/returns also serves to protect a portfolio of long investments in periods of stock price volatility, especially when investors become complacent and prices become frothy and excessive.

On the topic of investing in healthcare, it is worth noting that “biotech” as a subsector tends to garner headlines, but healthcare is far broader. (Philosophically, we believe that there are compelling reasons to invest in select biotech stocks, but many stocks are driven by hype and/or emotion and, as such, are generally not good investments.) There are approximately 2,000 public healthcare companies across the globe. There are hospitals, managed care organizations/HMOs, service companies, business-to-business providers, consumer healthcare companies, drug stores, medical device companies, pharmaceutical companies, healthcare IT companies, etc. The sector is large, diverse, heterogeneous, and filled with uncorrelated investment opportunities. By focusing on this sector continuously and consistently, we are able to find opportunities, both long and short. One constant seems to be that new opportunities continue to arise. This makes healthcare an attractive universe in which to invest.
I thank Michael Castor for sharing this extremely informative piece on investing in healthcare. I invite all of you to read his blog, Quintessential. For those interested in Sio’s monthly letters, they are available to people who request a logon to the Sio Capital Management website.

Michael and I had a chance to talk on Saturday morning. It was my "Big Fat Greek Easter" this weekend so I was busy going to church and then stuffing my face with lamb and all sorts of delicious Greek food, which I'll have to burn off over the next month (argh!). But I'm glad we had a chance to talk so I can learn more about him, his fund and his thoughts on investing in healthcare.

You'll recall I first discussed Sio Capital Management in a post covering 2013's best hedge fund manager. The first thing that struck me about Michael is how bright and dedicated he is. He literally works seven days a week and has an unparalleled passion for investing in healthcare. And he really knows his stuff. I've met a ton of hedge fund managers in my life and very few really impressed me (most of them are marketing geniuses). I even told him so straight out: "If I had a dollar for every time some slick hedge fund manager told me they had a 'niche strategy', I'd be a multi millionaire."

Michael is impressive because he's extremely knowledgeable and has constructed his portfolio to manage downside risk and target positive returns in all market environments. In other words, not only is he investing in a field where the barriers to entry are naturally high because it requires specialized knowledge, he also understands how to properly construct his portfolio to limit serious drawdowns.

In fact, in 2008, SIO Capital was up 10.8%. Since inception (June 2006), the fund is up 14% on an annualized basis, handily beating the S&P 500 and MSCI World Healthcare index. Their only losing year was 2010.

Even more impressive is the fund's risk profile. They achieved these results on the long and short side with little net exposure and the standard deviation (a measure of volatility) of their returns was half that of the S&P 500 (7.9% vs 16.2%) and less than that of the MSCI World Healthcare index (13.6%).

I did ask Michael about 2010 and why Sio was down 6.1% (always ask tough questions about losing years). He replied:
 “In 2009, I hired three analysts. They had different styles. I did not have a full appreciation of the challenges of growing the team this quickly and the degree to which maintaining Sio’s style was critical. For example, some of the analysts gravitated toward more speculative investments than I was comfortable. Ultimately, as the portfolio manager, the track record and the responsibility lie with me. Looking back, 2010 was a year where the analysts, despite being good people, were distractions in aggregate rather than overall contributors to generating performance. I made the hard decision to part with all of these analysts in late 2010. It was the right thing for the team at Sio and for our investors. Despite a challenging year, I look back and assert that not only do I now have a better understanding of who is the right team for me, I also know how I will perform in a challenging environment. I rebuilt the team with extraordinary people who share and embrace Sio’s approach. I believe our results since that time suggest that this was the right course of action.”
During 2010, four funds of funds that made up close to 75% of the assets pulled out. Sio currently manages approximately $100 million. Michael speaks fondly of his early investors, who have mostly remained with the fund since inception. Several are doctors Michael knows well, including his professors (shows you the vote of confidence they have in him).

I told Michael to forget about funds of funds. They're on the verge of extinction and charge an extra layer of fees which is why they're nothing more than hot money chasing the next home run (there are a few exceptions). I told him to focus on pension investors.

It should be noted that Sio Capital has a capacity of roughly $750 million and Michael will stick to this. I mention this because a lot of the pension funds I know won't look at any fund they can't write a minimum ticket of $100 million. He told me: "That's fine, we are not going to grow assets at the expense of performance." I liked that answer a lot because it shows me his focus is 100% on performance.

We also talked about markets. I told him I saw the latest biotech selloff as a huge buying opportunity and was focusing on stocks the Baker Brothers own which got sliced in half and more. I used the selloff to add to my holdings of Idera Pharmaceuticals (IDRA), which is up 17% today on heavy volume. I told him "I'm a biotech beta junkie" but admittedly have to withstand crazy, CRAZY swings in my portfolio which would give heart attacks to any retail or institutional investor (given me plenty of anxiety attacks too!).

He told me that Sio's exposure to biotech varies depending on the opportunity set. In general, Sio’s weight in biotech is in the range of 20-25% of the portfolio. This includes some early stage companies as well as established, large-cap biotech companies such as Biogen (BIIB) and Amgen (AMGN). I asked Michael to name a few of the early stage companies he finds interesting. He told me he likes TG Therapeutics (TGTX), which the Baker Brothers are top holders of, and Retrophin (RTRX), a company started by Martin Shkreli, a notorious short seller. He also told me he was skeptical that Neuralstem (CUR) was going to succeed in their stem cell trial for ALS and felt similarly about Inovio Pharmaceuticals (INO), a company that macro king Louis Bacon bought in the last quarter.

Sio's portfolio is diversified across healthcare. Sio invests in healthcare service companies, medical equipment manufacturers, drug makers and other healthcare stocks. They have 40 longs and 40 shorts. Michael told me they now have no HMOs because they find them fully valued but that can change in the future if opportunities arise.

For full disclosure purposes, Sio reached out to me to introduce themselves after I first mentioned them on my blog. After being impressed by Michael when we spoke, I asked him to provide me with his thoughts on investing in healthcare. The fund has not provided me a dime for this post.

Lastly, as often is the case with smaller funds, Sio Capital has “manager risk.” God forbid a bus runs over Michael Castor, they're screwed! They will have to liquidate holdings and return money to their investors. Michael understands this. The fund documents contain a “key-man” clause which states that if Michael becomes incapacitated or otherwise unable to manage the portfolio, the fund will be liquidated and money will be returned to investors. Michael told me, “Sio’s responsibility is to always protect and do right by our investors.”

Please remember to donate and/or subscribe to this blog by going to the top right hand side of this page. All you need is a PayPal account and your financial support is very appreciated (takes a lot of time and energy to do these blog posts!!!).

Below, Michael Castor, founder of SIO Capital Management, talks about ways his portfolio is being impacted by the Supreme Court's decision to uphold the majority of President Barack Obama's health-care overhaul. Castor, speaking with Deirdre Bolton on Bloomberg Television's "Money Moves," also talks about the decision's effect on the medical community (June 2013).