A model portfolio of large cap stocks

I’ve started an experiment where I’m keeping a public portfolio of large cap stocks via the Motley Fool CAPS system- you can view it here.  I would like to see if I can generate value on the long side… something that I find much, much more difficult than shorting.

My criteria are:

  1. Pick only the quality businesses in a particular sector.  For example, Dollarama is the clear leader among discounters.
  2. Not overpriced.  For that reason, Amazon and Netflix don’t make the cut (just look at what happened to Amazon during the Dot-Com Bubble).
  3. I avoid industries where there are no clear industry superstars.  Oil and mining stocks simply don’t make the cut as none of them are quality businesses.
  4. Lastly, I avoid dying or shrinking industries.  Profits ultimately don’t grow in dying industries and therefore those stocks almost never do well.

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Healthcare inflation is driven by bad medicine

According to the Commonwealth Fund (an endowment-supported US foundation), US healthcare spending has increased to 16.6% of GDP in 2014.  Other countries have seen less rapid increases in healthcare spending.  For the most part, inflation is being driven by doctors with a vested interest in pushing medical services, expensive treatments, and pharmaceutical drugs.  To my surprise, what I’ve found is that many aspects of modern medicine aren’t supported by rigorous scientific evidence.  While the FDA drug approval process superficially appears to be scientific, it often isn’t.  One way that pharma companies game the system is to prove that a drug (e.g. statins) affects a dubious biomarker (e.g. cholesterol) rather than prove that the drug causes more good than harm (e.g. lower mortality).

Unfortunately, mainstream views on science and medicine are quite ignorant of what goes on.  We are taught to only trust medical advice from “trained and licensed professionals”.  Much of society worships technology and has blind faith in the claims made by medical authorities.  I would argue that this environment is a fertile ground for the trend in healthcare inflation to continue going forward.  And if that trend continues, it is likely that American health insurance stocks will continue to do quite well.

Pharmaceutical companies researching active placebos may also do quite well.

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Drug reimbursement shenanigans

In the drug industry, there are different types of abusive practices that occur:

  1. Drug companies encouraging off-label use (and/or “recreational” use) of their drugs, potentially harming patients’ health.
  2. Drug companies encouraging doctors to increase dosages and drug use, potentially harming patients’ health.
  3. Drug companies encouraging waste to increase the volume of drugs sold.
  4. Pharmacy benefits managers (PBMs) selling out their clients (payors) in exchange for kickbacks from drug manufacturers.
  5. Drug manufacturers using “specialty” pharmacies to bilk payors, tricking the payors into reimbursing expensive drugs that they would otherwise not reimburse.  Unlike traditional pharmacies, captive pharmacies can go the extra mile to obtain (possibly improper) drug reimbursement for the drug manufacturer.

This blog post will look at #4 and #5.

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Valeant: Is giving away cheap drugs a good business model?

Valeant has a reputation for significantly increasing the prices of its drugs.  The truth is a little more complex than that.

Through its so-called “specialty pharmacy” channel, Valeant engages in an unusual practice of sending drugs to consumers without a guarantee of receiving insurance reimbursement from private payors.  If the reimbursement claim is ultimately denied, Valeant ends up selling a drug at firesale prices.

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Closed my ESRX position

  1. My thesis was that ESRX would grow its profits.  In the last quarter it did not.  Something is wrong and I don’t understand what it is.
  2. I goofed because I don’t understand the implications of Obamacare as well as I should.  I can’t figure out where the macro environment for Express Scripts is headed.
  3. I don’t like how Express Scripts’ integration costs have supposedly gone up.  It seems like they may be trying to manipulate their adjusted earnings.  I really dislike that type of behaviour.  Honest managers tend to be better at running businesses.  Managers may fail to correct mistakes if they do not want to recognize that they made them in the first place.

In general, I know I’ve been much better at identifying bad stocks than good stocks.  I definitely have room for improvement on the long side.

*Disclosure: I sold all of my ESRX calls.

When I wrote about ESRX on August 1, 2013 the stock closed at $65.56.  It is currently trading at around $67.32 (+2.7%), underperforming the NASDAQ, S&P 500, and other indices.  I happen to have made an overall profit on my calls because I sold ESRX shares in January when my Jan 2014 calls expired.

Pharmacy Benefit Managers / Express Scripts (ESRX)

Express Scripts (ESI) is the largest pharmacy benefit manager (PBM) in an industry where scale is a competitive advantage.  It has been able to compound earnings, free cash flow, and free cash flow at very high rates (over 20%) over the past ten years.  Fundamentally, I believe that Express Scripts’ returns are mostly driven by its CEO, George Paz, who has held the position since 2005.  In the past, ESI never had the benefit of scale.  Its success was driven by the quality of its management.  In the future, ESI will begin to see advantages and disadvantages from its larger size.

On the other hand, the PBM industry has some dubious practices that creates regulatory risk.  The PBMs are rarely transparent with their customers and have often taken kickbacks from drug manufacturers.  There is a chance that future government intervention will target such practices.

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