Current Market Environment
Cases of whiplash must have spiked lately. After all, in a few short months, market commentators have abruptly transitioned from: “inflation is transitory” to “inflation might be more persistent” and now “prepare for stagflation!” As discussed in our last writing, the stock market had appeared to be fully in the Fed’s camp, perceiving the recent spike in inflation as a temporary phenomenon. This sentiment persisted through much of the third quarter, as COVID-19 cases once again ramped higher due to the rise of the more transmittable Delta variant. The increase in cases triggered concerns of a slowdown, a reduction in some estimates of economic growth, a continued decline in U.S. government bond yields, and investors flocking back to technology and growth stocks. These market trends quickly reversed late in the quarter, as the Fed increased their expectations for inflation and indicated they would start tapering asset purchases sooner than expected. Government bond yields quickly lifted, with the all-important 10-year Treasury rising from around 1.30% to 1.54% over the next several trading days. Value stocks, especially banks and financial service companies, rallied in tow.
While concerns over a Delta-variant induced slowdown have abated somewhat, supply bottlenecks around the world have become markedly worse as demand for goods has outpaced the ability to get those goods to market. Part of the blame has been placed on a lack of truckers to transport the goods. It was recently reported that nearly half a million cargo containers were sitting off the coast of California as cargo ships are waiting to be offloaded – with some potentially waiting for a month. This not only puts the Christmas shopping season at risk for retailers, but has also already led to an increase in the price of many goods. Meanwhile, energy prices around the world have taken off, also due to supply/demand imbalances. For example, liquefied natural gas prices (heavily relied upon in Europe and Asia) have skyrocketed on those continents to $40/mmbtu from $6/mmbtu in late February, while oil has been driven up to over $80 a barrel, from near $50 at the beginning of the year.
While most of these supply issues may prove to be temporary, the inflationary impacts could be more persistent – especially if labor shortages lead to wage increases, which tend to be sticky. Will these inflationary pressures be such that they cause enough demand destruction so as to lead to stagflation? As we’ve stated before, we do not purport to be economists, however, we do take some comfort in the overall health of the consumer. As can be seen in the chart below, the U.S. consumer’s balance sheet is currently in great shape, with debt service as a percentage of disposable personal income at record lows. This has undoubtedly been aided by massive government stimulus, and should help consumers withstand this period of rising cost pressures much more readily than they would have, say, a decade ago.
With that said, it is appropriate to consider the portfolio implications if we are indeed headed towards a period of persistent inflation and stagnant economic growth. While no two periods are directly comparable (for example, the environment today is very different than that of the 1970’s, when we last saw stagflation), we would expect defensive sectors such as consumer staples and healthcare to outperform given their more stable business models and ability to exhibit pricing power. We would also expect a flight to quality generally, including the outperformance of companies with above-average balance sheet strength. Notably, Morgan Stanley recently issued a report which looked at periods in which “…markets assigned a non-trivial probability to stagflation as a tail risk...” Their data showed that defensive sectors did indeed outperform during these periods, as did energy. In addition, credit spreads widened as fears of stagflation entered public discourse, adding credence to our belief that quality would outperform in such an environment. Also worth noting: according to work performed by RBC, banks outperformed through three stagflationary periods during the 1960’s and 1970’s.
Portfolio Spotlight - Merck
Long-time portfolio holding Merck & Co. [(MRK), 2.2% allocation] is a global healthcare company which engages in the research & development of pharmaceuticals, vaccines, and animal health products. Given the company has recently been in the headlines and is the largest healthcare position in your portfolio, an update seems timely. Merck recently announced interim Phase III clinical data for Molnupiravir, an oral antiviral for the treatment of COVID-19, which indicated the drug reduced the risk of hospitalization by approximately 50%. Merck submitted an application for Emergency Use Authorization (EUA) with the FDA based on this clinical data. The approval of Molnupiravir may potentially be a major victory in the fight against COVID- 19, as it would be the first antiviral that could be taken at home. Some have estimated that successful antivirals will receive global orders from governments in excess of $20 billion – given the lack of effective antivirals, this is a potential windfall for Merck.
We view Molnupiravir as an embedded “call option,” and not an essential part of the thesis. In our opinion, Merck has continually been under-valued by the market since we first initiated the position in 2013. The company is projected to generate over $14 billion in free cash flow in the next calendar year, equating to a healthy 7% free cash flow yield. The 11.6x forward P/E ratio is an approximate two multiple point discount versus the peer group, and MRK currently offers a robust 3.5% dividend yield. This is despite an estimated double-digit EPS growth CAGR over the next five years, not including potential upside from Molnupiravir. We also like how the pharma sector is currently out of favor by generalists, with the sector being inexpensive on an absolute and relative basis.
On a sum-of-the-parts basis, we value Merck (which currently trades around $80/share) at just over $100 by valuing the core pharmaceutical / vaccine and animal health businesses separately. This results in another embedded call option in the stock if the company decides to spin-out or sell the higher multiple animal health business, which could potentially trade at 30x+ EPS.
The primary reason for Merck’s steep discount is ironically due to the major success of its blockbuster cancer drug Keytruda. This drug represented 30% of Merck’s sales in 2020 and continues to grow, continually surpassing Wall Street expectations as indications for the drug keep expanding. By way of example, when we first initiated our position, Street estimates saw Keytruda peak sales of around $4 billion…The drug is expected to produce revenues of close to $20 billion in 2022. Despite the success of the drug, investors are concerned with Merck’s ability to replace the Keytruda’s revenue following the entrance of competition from generics (the first of a series of major patent expirations begins in 2028).
That said, we are encouraged by steps the company is taking to diversify away from the blockbuster cancer drug. This year, Merck partnered with Gilead Sciences to jointly develop and commercialize treatments for HIV. Merck’s Islatravir and Gilead’s Lenacapavir have potential to become blockbuster drugs if successful in late-stage trials. These drugs represent potential game changers in the management of HIV. Merck is also leveraging its strong balance sheet to supplement the internal pipeline by engaging in M&A. Recently, Merck announced the $11.5 billion acquisition of Acceleron, which is developing a pulmonary hypertension drug with strong clinical results. This drug is another asset which can achieve multi-billion dollars in annual sales. This deal is in addition to small bite-sized acquisitions over the recent past, such as the purchases of Pandion and Peloton (not to be confused with the fitness company).
Merck retains the optionality and capacity to engage in additional business development opportunities. The company maintains a strong balance sheet which will enable the company to pursue additional M&A and is rated A+ by S&P. It is also estimated that Merck will generate $100+ billion in free cash flow over the next five years. We expect a large portion of free cash flow will be used to support business development. We also applaud the spin-out of the Organon segment into a publicly traded company, which occurred in June. Organon is a collection of legacy off-patent drugs, biosimilars, and women’s health products. The rationale for the spin-out was to prioritize higher-value and faster-growth franchises within Merck, achieve $1.5 billion in pre-tax expense saves over three years, and use $9 billion in tax-free cash proceeds from the spin-co to reinvest into the pipeline. As a result, we expect substantial operating margin expansion in coming years and a sharper focus on product research & development.
Additionally, we feel investors are shrugging off Merck’s internal pipeline and current (non-Keytruda) drug lineup. The company is pursuing large potential opportunities within its oncology, vaccine, hematology, and immunology businesses. We also like the growth prospects for approved assets such as Gardasil and Lynparza, along with steady and more predictable growth from the vaccine and animal health franchises.
Merck has a variety of options, and ample time to replace lost revenue from Keytruda’s initial loss of exclusivity in 2028. While investor sentiment remains low for Merck, positive portfolio readouts, the success of Molnupiravir, and attractive M&A, can positively sway investor perception over time. Also, the loss of Keytruda exclusivity in 2028 is the worst-case scenario. Through various co-formulations under development, Merck can potentially extend the effective patent life of Keytruda well into the next decade. Additionally, the patent expiration is not a revenue “cliff-event” per say. It often takes years for generic competition and prescriber adoption to gradually erode sales of the name-brand drug they are replicating. In the iconic words of Mick Jagger, we can claim “time is on my side” when it comes to your investment in Merck.
2021 looks to be a transitional year. We continue to be in the midst of an economic recovery, following the coronavirus-induced recession of 2020. Continued progress on vaccinations and therapeutics should allow the U.S. economy to return to more familiar footing with the resumption of dining out, air travel for business and pleasure, and large group gatherings. The 2020 United States elections, although closely contested, ushered in a change in administration with attendant changes in the agenda around stimulus, spending, taxes, and trade. The razor-thin margins in Congress are likely to temper any radical policy shifts.
While interest and mortgage rates have lifted, they are coming off historically low levels. We are seeing reinflation in many areas of the economy, and are watching this closely given the historically high levels of government spending here and around the world. We are carefully monitoring aggregate corporate debt levels (especially BBB- debt which is a single notch above junk status), currently above pre-2008 crisis levels and loom as a potential problem absent continued aggressive Fed support. Unemployment has shown significant improvement, but labor continues to be an issue, as the participation rate continues to be low and labor shortages are impacting many industries.
In our estimation, overall equity valuations remain at elevated levels. The high valuations of a small number of enormous technology companies certainly exert upward pressure to the overall averages. Aggregate earnings are quickly recovering, however unevenly. Certain industries such as hospitality, entertainment and travel, which are tied to the success of the vaccine rollout plan, will take longer to return to pre-coronavirus levels. Treasury and high-grade corporate bond yields look unattractive. In any case, value investing is ripe for a period of outperformance, and the bargains inherent in your portfolio should attract acquirers and other investors over time. Meanwhile, we still believe equities represent a superior asset allocation alternative to bonds over the longer term.
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