Interest rates seemed to be on a sustained uptrend—heavy emphasis on seemed—as we sent the October 2013 issue of Investor Advisory Service
out to our subscribers. The IAS
emphasizes fundamental “bottom up” stock analysis over “top down” macroeconomic analysis, but we do keep an eye on the major macroeconomic indicators, and when it comes to major indicators interest rates are one of the most important.
Higher interest rates cause trouble in the stock market for at least three reasons. First, they can dampen economic growth, which in turn dampens corporate earnings growth. Second, stocks are long-lived assets which pay investors back slowly through rising dividends, and higher interest rates make future income streams less valuable in today’s dollars. This “discounting” of future income is one of the most fundamental principles of investment finance. Third, the stock market competes with the bond market for investor dollars, and higher interest rates make bonds look more attractive on the margin. Nonetheless, we urged our readers to hang in there.
The main reason why didn’t think it was time to withdraw from the market, despite rising rates, was that we didn’t believe the normal logic of “rates up means market down” necessarily applied in a world where interest rates are kept artificially low. In our mind, interest rates were going from “preposterously low” to merely “weirdly low,” and the fundamental calculus behind rising stock prices remained largely intact. Here’s how we phrased our thinking twelve months ago:
Interest rates have been detached from reality for several years, so much so that we question their current value as an indicator…While the stock market initially quaked in June after interest rates had moved up for six weeks, the market seems to have calmed down over the past three months even as interest rates have moved higher.
To help fight the fears that rising rates naturally engender, we also pointed to a number of positive economic indicators, including near-record auto sales, better employment figures, an uptick in Chinese industrial data, as well as some simmering improvement in the big kahuna of all U.S. growth statistics: GDP. Investors who saw the glass as half full have been rewarded. Including dividends, the S&P 500 has gained 25% over the last twelve months. As for interest rates, they quickly reversed course, a sobering reminder that if timing the stock market is almost impossible, timing the bond market is no easier.
Each month we feature three companies we think are especially interesting and potentially timely. Let’s take a look back at one feature stock from the October 2013 issue, Santarus. The company develops, or developed—more on this introduction of the past tense later—specialty drugs for small to mid-sized indications. The company had some interesting assets in development, the best of which was a recently-approved ulcerative colitis drug. This drug, called Ulceris, comprised just 18% of total sales, but was growing fast with lots of potential runway ahead. Meanwhile, the company’s largest drugs were facing patent expiration in 2016, so the downside could be severe if new drugs failed to grow and replace the old ones. We measured the risks against the opportunity and wagered that Santarus could grow right through its pending patent cliff.
As it turned out, we weren’t the only ones watching Santarus closely. This company’s stint in the IAS would turn out to be short and highly profitable, as it was acquired by Salix Pharmaceuticals (NASD:SLXP) in early November, about a month after we first showed it to our subscribers. Salix had an existing ulcerative colitis treatment, so they were in excellent position to judge the prospects for Ulceris. We would never recommend a stock purely on the basis of its potential as an acquisition target, but when a new treatment comes along, it’s not unusual for the incumbent who owns the current standard-of-care drug to swoop up the new challenger, especially if it perceives a real threat of being displaced. The transaction was all-cash and went off at $32.00 per share, a 48% premium to the stock’s price when we wrote our October feature. That’s a very nice return for a holding period of about one month (technically, the acquisition closed in early 2014, but investors who sold immediately after the buyout offer got most of that premium). We see the IAS as an idea-generator, nothing more. We don’t want our readers to act impulsively and buy a stock just because we happened to feature it, but this was certainly a case where you had to act fast to get in on the gains.