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Cutting Through The Rhetoric In Pharmaceutical Stocks

By Mustafa Sagun, Chief Investment Officer, Principal Global Equities It’s easy to get wrapped up in the headlines when it comes to investing. But for long-term investors, it’s important to separate rhetoric from reality. This was demonstrated most recently in the public outrage over Turing Pharmaceutical’s decision to raise the price virtually overnight on Daraprim, a drug that treats the parasite infection tonoplasmosis, from $13.50 a pill to $750 a pill – an increase of 5,000%. According to industry estimates, drugs such as Daraprim usually see a 3% to 20% annual increase. The decision made on September 21 by the firm was pounced on by presidential candidates, such as Hillary Clinton who proclaimed, “Price gouging like this in the specialty drug market is outrageous. Tomorrow I’ll lay out a plan to take it on.” It wasn’t long before the company reversed course on its product price increase, but nevertheless, the damage had been done as the firm’s decision to increase the price of its product had worked its way into financial markets, particularly impacting healthcare stocks. Since then (September 21 to October 6), the S&P 500 healthcare stocks underperformed the S&P 500 index by about 5%, giving back its year-to-date outperformance. This was mainly driven by ETF selling, as evident from high transaction volumes in key healthcare ETFs (see portfolio insight for more on why ETF selling is an opportunity for fundamental stock pickers). Political rhetoric aside, let’s take a closer look at the reality in this situation to determine if there’s any real negative impact to the fundamentals of healthcare company stocks. The Reality: The reality is that there’s no regulation without legislation. More specifically, there’s no legal way for a sitting president, or any political candidate for that matter, to regulate drug pricing in the United States. Only a change in current laws could do that! And bipartisan legislative action is highly unlikely for at least the next two years or for that matter, perhaps even longer. The other reality is that financial fundamentals are better than ever for biopharmaceutical companies. Business models, product offerings, pipelines, and management quality are considerably better now than they were 10 years ago, resulting in sustainable earnings growth for these companies that is superior to most other sectors of the S&P 500. Another key point is that earnings are stable, as are earnings estimates and guidance. While some stock prices are down more than 20% since mid-summer highs, valuations are attractive and, in fact, quite compelling on a PEG (price earnings per unit of earnings growth) basis. So, the relative underperformance experience cannot be explained by earnings and fundamentals. Rather, the fact of the matter is that short-term concerns, without earnings support, create opportunities for long-term investors. Granted, the healthcare sector has been a long-term winner within the S&P providing a 21% annualized return versus 15% for the S&P 500 since 2012; thus, a pullback is normal. However, we should still recognize that the healthcare sector trades at a lower multiple than the market as a whole while providing higher earnings – two sought out characteristics for fundamental investors. Our healthcare analysts acknowledge that the cloud of uncertainty over drug prices may persist for some time. However, we believe this is an opportunity to take advantage of cheap valuations in companies with improving earnings and fundamentals, as fundamentally nothing has really changed for these companies. They just got cheaper! Portfolio Insight: Focusing on Company Fundamentals As long-term, research-driven fundamental investors, we try to cut through all the rhetoric to focus on the company-specific information that affects earnings and valuations. We believe that it’s important for long-term investors not to paint an entire sector, and every company within that sector, with the same brush. After all, ETF selling by thematic investors is an opportunity for fundamental stock pickers. In other words, a healthcare ETF sells all stocks based on their association to the sector, whereas fundamental investors may buy back a select few due to their superior fundamentals. That’s the essential nature of a bottom-up stock picker; remain calm, stay the course, and focus on sustainable earnings growth that has valuation support. At the end of the day, we seek out opportunities to exploit the behavioral biases that hype and rhetoric create. (click to enlarge) While there are near-term headwinds stemming for the drug price control rhetoric from democratic candidates, fundamentals and earnings have not changed and the recent price weakness has provided further valuation opportunities.

Tactical Asset Allocation Portfolio Performance: Theory Vs. Reality

One of the biggest challenges in implementing Tactical Asset Allocation (TAA) portfolios is coming as close to the theoretical returns as possible. Theoretical returns are based on index returns, which are not available in the real world. In this post, I’ll explore the major items that keep investors from achieving published theoretical returns of TAA strategies, and discuss some ways to minimize the gap between theory and reality. This is definitely an advanced topic, but a critical one that I really never seen addressed in the financial blogosphere. First, let’s look at the three big reasons for the gap between theoretical and real returns for TAA portfolios. Poor index replication: TAA portfolio returns are based on indexes, e.g. small cap momentum, for some of which no reasonable investable ETF exists. This is becoming less and less for an issue – for e.g., the PowerShares DWA SmallCap Momentum Portfolio ETF (NYSEARCA: DWAS ) is a potential candidate for small cap momentum – but many of these new ETFs are still quite small. Even if an investable ETF exists, there will be some tracking error between its index and the ETF. Fees: There are two sources of fees – trading fees and management fees. Many of the ETFs in TAA portfolios are available as commission-free ETFs, but some are not. And of course, every ETF has a management fee, which detracts directly from the index returns. Slippage: This is the largest source of the gap between theoretical TAA returns and real TAA returns. TAA portfolios are based on monthly investment signals. Monthly investment signals are based on closing ETF prices. Actions based on those signals are done on the following trading day. Any difference between the closing ETF price and your trade price the following day constitutes slippage. For example, a sell signal was generated on August 31, 2015 when the Vanguard Small Cap Growth ETF (NYSEARCA: VBK ) closed at $124.77. On the following day, September 1, VBK traded in a range from $123.53 to $121.06. Selling VBK in that range would generate a difference from the theoretical sell price (the previous close) of 1-3%, depending on where you sold during the day. And this does not even account for the bid-ask spread. Needless to say, that would impact your returns. Usually, it is not as bad as this example, and the slippage can even go in your favor, but in general, it detracts significantly from theoretical returns. Now, let’s put these reasons into context. I ran some backtests with the AGG3 and AGG6 strategies with some different slippage numbers. Since these backtests use real ETFs, all management fees are taken into account. The results from March 2007 through mid-September 2015 are below. If you were able to trade at the theoretical closing price of the ETFs, then with AGG3, the return would have been 13.77% annualized over the period. With just 0.25% negative slippage on every trade, that return would have decreased by 2%, annualized to 11.77%. And with 0.5% negative slippage per trade, that annualized return would have been only 9.85% annualized. As I like to say, slippage kills! BTW, any portfolio strategy has the exact same issues – even “buy and hold”. The issues are exacerbated when a strategy is more active, and thus, trades more often. OK, so what can we do about this? Let’s address each reason individually. For poor index replication, we can always be on the lookout for better-constructed ETFs that more closely match the indexes, and do so at reasonable costs. As I said earlier, this is less and less of an issue today. As far as fees go, we can look for the lowest-cost commission-free ETFs that best implement the index. Sometimes, this can conflict with the first goal of good index replication. For example, is DWAS a better choice for small cap momentum at 0.6% per year in fees, versus VBK, which is really a small cap growth ETF (not momentum), but is only 0.09% per year in expenses? In other words, the better index replication may not be worth the extra fees. And then there is the big one – slippage. In theory, the solution is easy. Trade as close to the theoretical model price as possible. At the minimum, this ideally means the use of high volume, low bid/ask spread ETFs. I’ll give you my favorite example. The Vanguard Long-Term Government Bond Index ETF (NASDAQ: VGLT ) trades 50K shares per day, at an average bid/ask spread of 0.2%. The iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) trades 9M shares a day, at an average bid/ask of 0.02%. Which one would best minimize slippage? TLT by a long shot, despite the slightly higher management fee (0.15% versus 0.12%). So, to minimize slippage, we may sometimes actually end up using different ETFs. You may also want to change from end-of-month portfolio signals to some other day during the month to avoid volatile month-end periods due to options expirations, portfolio window dressing, etc. Then, at the advanced end of the spectrum, you can actually ‘trade the close”, i.e., execute your trades as near the end of trading as possible on the last day of the month (the day that generates your portfolio signals). The use of conditional orders and MOC (market on close) orders greatly simplifies this strategy. I’ve been working on this strategy most of the year, and have found it quite effective in minimizing slippage. Also, even the choice of brokerage can impact slippage. I have stopped using TAA strategies at certain brokers, due to poor execution prices. In summary, there will always be a difference in model returns versus real-world returns. The question is, how can we minimize these gaps? With attention to detail in choosing the best, liquid, low bid/ask, low-cost ETFs and some smart trading strategies, you can keep the gap down to a minimum.

Emerging Markets Vs. The S&P 500

By Jim Freeman, CFP ® The below chart shows how much emerging market equities have underperformed the S&P 500 (NYSEARCA: SPY ) since the financial crisis. It also shows how these stretches of underperformance and outperformance are not unusual. The key to success in investing in emerging markets is to rebalance and add to positions during periods of underperformance, and to rebalance and take profits during periods of outperformance. Having a dedicated allocation to emerging market equities and rebalancing back to this allocation systematically helps you accomplish this. See the graph below to see what would have happened to returns if an investor had held a 50/50 portfolio of emerging markets and the S&P 500 and rebalanced it back to 50/50 at the end of each year during this period. As you can see, the returns would have been 11.6%, or 1.5% better than those from the S&P 500. (click to enlarge) We normally allocate roughly 3-6% of a clients’ portfolio to emerging market equities. We use either the Vanguard Emerging Market fund or the DFA Emerging Market Core fund – both are highly diversified. The Vanguard fund holds 980 stocks, and the DFA fund holds 3,807 stocks. Many people believe emerging market equities will provide higher returns than the S&P 500 over the next market cycle, due to their recent underperformance. We would not be surprised to see this happen, since it is a well-established pattern, as the first graph illustrates. We plan to keep our clients’ allocation to emerging markets consistent, and we will also do tax swaps to lock in losses that can be used to offset gains in other areas of their portfolios. *The above graphs were taken from Ben Carlson’s blog, “A Wealth of Common Sense – Personal Finance, Investments & Markets”. Share this article with a colleague