One year ago, the S&P 500 was bouncing back strongly from a 3.5% selloff in January 2014. In the words of Yogi Berra, the first two months of 2015 look like déjà vu all over again in the equity markets. The S&P 500 has once again bounced back from a 3% dip in January, and is currently hitting new all-time highs. Looking back at the conclusion to our “Investment Comments” of March 2014, we advocated continued selective equity exposure with a focus on downside risk:
In a continuing environment of slow, steady growth, low interest rates, and somewhat elevated equity prices we continue to stress the importance of carefully selecting stocks that provide reasonable upside potential at moderate risk.
This proved to be sound advice, as the S&P 500 went on to deliver a 13.5% total return in 2014, but left many active managers far behind as they dealt with the carnage of any and every pick exposed to the energy sector.
In our commentary we also suggested an improvement in the housing and automotive markets, believing they would benefit from continued low interest rates as 2014 progressed. Indeed, after a rough first quarter, the housing market bounced back nicely, as total housing starts closed the year up 8% from 2013 to their highest level since 2007. After a weather-driven bad first two months of 2014, the auto market also surged ahead in the rest of 2014, with 16.5 million new autos hitting the streets, up roughly 6% from 2013 to their highest level since 2006.
One of the three featured companies from last March’s IAS issue that made big headlines and caused a lot of debate among investors in 2014 was Gilead Sciences (NASDAQ: GILD). We have been bullish on Gilead for quite some time, and the shares have a had a great run the last several years, but we thought it deserved highlighting once again last spring as a top pick in a relatively expensive market. Our investment thesis in the March issue centered on a combination of Gilead’s new blockbuster HCV franchise and its strong and growing pipeline of new drugs:
Gilead Sciences has been on a roll. Since being recommended one year ago, the stock has slightly more than doubled, largely due to the expectations of blockbuster sales for the firm’s recently launched Hepatitis C Virus drug, Sovaldi. After this rise, the stock carries quite a high P/E ratio of 45. However, we believe the strength of Gilead’s drug pipeline justifies this lofty price and provides the opportunity for further gains.
After our recommendation printed in March, the stock price proceeded to dive from the low $80s to the mid $60s in early April amidst a sector-wide biotech sell-off and concerns over pricing pressures on Sovaldi from the government and private insurers. Interestingly enough, the shares bottomed out around $65, which was the contemplated low price in our risk/reward analysis in the March commentary. This proved to be an extremely attractive entry point, as the stock rebounded almost immediately in mid-April, surging all the way to a closing high of $114 at the end of October, with a brief 10% dip in mid-October in the market-wide pullback.
The shares ended 2014 by selling off to the mid $90s due to price competition from AbbVie’s rival HCV drug, Viekira Pak. After a quick rebound and consolidation in the $100-$105 range, the shares slid again after Gilead’s fourth quarter earnings report in early February seemed to confirm investors’ worst fears about a price war, with management forecasting average discounts on Sovaldi/Harvoni in 2015 more than doubling to 46%. The stock has since climbed back to about $102. Despite all the volatility, Gilead shares appreciated 24% since our March recommendation, better than the S&P 500’s 17% total return over the same period.
In our comments in March, we must admit we underestimated the impact of price competition when we stated:
There is competition in the HCV market but much of it looks to be behind Gilead. AbbVie has released Phase III studies of its three molecule combination, but its treatment requires ribavirin and multiple pills per day.
As we have seen, a pricing war of some sort was inevitable because AbbVie’s new treatment regimen was clearly inferior, which left them with only price on which to compete. AbbVie initiated the price war by securing an exclusive deal with Express Scripts for their new Viekira Pak at a significant discount, sending Gilead shares into a tailspin at the end of 2014. Gilead fired back with several deals of its own including CVS, Anthem, and Humana, but this came at the cost of undisclosed price discounts.
The shares remain weighed down by investor fears stemming from management’s guidance for a 46% average discount on Sovaldi/Harvoni and conservative 2015 sales guidance that came in below analyst expectations. The below excerpt from a recent Credit Suisse downgrade encapsulates the current irrational view of the stock in the market right now:
We are downgrading on the back of lower medium/long-term hepatitis C virus (HCV) franchise revenues, which in turn is principally driven by lower net pricing. For the stock to work again, we believe the street will need to refocus on the pipeline - this is most likely a mid/late 2015 event in our view.
The street seems to be ignoring the fact that Gilead has been striking deals on discounts in exchange for greater patient access. It is highly likely that the discounts will be more than offset by access to a significantly larger pool of HCV patients over the next several years. Not to mention, the market seems to be completely ignoring the company’s blowout revenue and earnings numbers for 4Q14 and FY2014 that beat expectations. In addition, management continues to deliver shareholder value, initiating its first dividend which will provide a roughly 1.5% yield at current levels, and adding an enormous $15B to its existing stock repurchase program. There is much still to love about this stock.