By Paul Nouri :
This is the seventh article in our Positioning for 2012 series. Readers can find the entire Positioning For 2012 serieshere.
Paul Nouri has been managing Noble Equity Fund, LP, a healthcare-focused hedge fund, since January of 2008. In addition, he manages Noble Advisors, LLC, a Registered Investment Advisor. Prior to this, he worked on the sell side at Sidoti & Co. and Deutsche Bank covering various industries.
Seeking Alpha's Leland Montgomery recently spoke with Paul to find out how he planned to position clients in 2012 in light of his unique understanding of the ins and outs of the health care industry and the outlook for Medicare/Medicaid reimbursement trends.
Seeking Alpha(( SA )): How would you generally describe your investing style/philosophy?
Paul Nouri ((PN)): The fund invests in all sub-sectors of healthcare. Our core investment strategy is long-term value. We look for companies that are fundamentally sound with good growth prospects and that trade at a discount to their fair value. We are willing to wait out the volatility inherent in markets to realize significant profit potential from our investments. The top metric we typically look at to value companies is the ratio of enterprise value (defined as market capitalization - cash + debt) to free cash flow.
PN: We are currently overweight in healthcare services, and more specifically, hospitals. On average, the hospitals have declined 25% this year vs. the S&P 500, which is down 4%. Investors have sold on fear of pressures on reimbursement from Medicare as well as lower admissions that have yet to pick up substantially from the effects of the 2008 recession. Despite these pressures, hospital earnings have been up 10% per year on average during each of the past three years, due to cost cutting and acquisitions. Additionally, when the U.S. economy recovers, which it eventually will, hospitals have a significant amount of leverage to any upside in their admissions as they have right-sized their cost structures. We look forward to significant upside in the space as investor fears will be overshadowed by reasons to be optimistic on the earnings outlook. Some of the names in the space that we currently own include Community Health ( CYH ), Universal Health ( UHS ) and Health Management Associates ( HMA ) with a short position on Tenet Healthcare ( THC ) as a hedge.
PN: In the summer of 2011, while hunting for bargains in an otherwise expensive market, we came across Cambrex (CBM), a company that manufactures ingredients for pharmaceuticals. We liked the company because we saw a management team that had largely gotten it's restructuring behind it and was focused on profitable growth. Additionally, the company's 4.0x-4.5x enterprise value to cash flow ratio was less than 5x, a figure that quickly got our attention.
After doing our own research on the company and industry, we met with management to talk about business prospects and ended up taking a position in the company. We did not expect this to be a quick, high-return investment. We anticipated holding shares at least 12 months before being able to realize significant profits. Surprisingly, in an otherwise volatile market, shares of CBM are up 75% from our entry point. We have sold out of much of the position, but we still hold shares and anticipate some further upside.
China Medical (CMED) is a company for which we had high hopes, but it fell flat on its face in 2011. Much of the decline in the stock can be attributed to a run up in its receivables, in terms of days sales outstanding ((DSO)), as well as an overall negative outlook by U.S. investors on China-based companies. Our research has led us to believe that these fears are being priced into the stock too greatly and that shares appear well undervalued. Our China Health checks indicate that the run up in China Medical's DSOs is an industry-wide phenomenon which should abate in the next two quarters. As far as the China stigma is concerned, the company has a top quality auditor and has an experienced audit committee on its board of directors. Additionally, management has been purchasing stock throughout the year, giving us additional assurance that management has confidence in the company's prospects.
As for 2012, we think Stericycle (SRCL) may surprise investors to the downside. Investors are convinced that this is an unstoppable industry consolidation story. Since 1989, Stericycle has purchased nearly 250 companies worldwide in the medical waste industry. While these acquisitions have aided 15% compound annual growth rates on sales, Gross & Operating Margins are 200 basis points off their 2009 highs and are likely to continue to decline due to pricing pressure. Low barriers to entry breeds competition in the medical waste space and a willingness to undercut Stericycle to gain business.
Also, as health organizations are growing in size, they are putting big pressure on national contracts to get better rates. Stericycle will likely have to continue making acquisitions to attempt to maintain its current pricing. Since 2001, including acquisitions, the company has not produced any free cash flow. We are willing to overlook this sort of track record in a window of a few years, but when it becomes a long-term strategy, there is little cash for shareholders at the end of the day. As a result of the company's aggressive acquisition strategy, it owes $1.4 billion of debt.
Additionally, the company has recently been making a great deal of acquisitions overseas. We do not see how the company can produce any synergies by purchasing businesses in separate parts of the world that require service in those regions specifically. Finally, the shares trade at more than 30x enterprise value to free cash flow. Considering the headwinds the company faces in combination with what we see as aggressive consensus estimates on the Street, we think shares of Stericycle deserve a considerably lower multiple.
PN: The era of deleveraging began in 2007, when home equity lines were cut off and credit card limits reduced. Investors should remember that the United States has been underperforming for five full years. Five years of layoffs, underperforming equities, falling home prices and an overall uninspiring economic mood. A housing crisis became a financial crisis and then a sovereign debt crisis. We are at a critical juncture. Investors and asset allocators have a choice. Do we continue to be scared by headline news about countries with a GDP less than New Jersey (I'm talking about Greece) or do we focus on the positive and let the animal spirits take us out of a dark period?
There is actually much to be optimistic about. The fact that people have been paying off their debts the past few years brings greater stability to individual balance sheets. Additionally, it's likely that home values are close to bottom. A combination of tightening housing supply and record low interest rates should be enough to put people into homes. Low interest rates should incentivize borrowing. This has been the case with corporate borrowing, which has taken off as the combination of low equity prices and low interest rates have created perfect opportunities for companies to leverage up. While the latest recession hopefully taught people to be more responsible with their finances, it is doubtful that consumers will worry about paying off debt in an era of record low interest rates.
PN: I personally don't remember a time when sentiment on the economy and on political will was this low. In past recessions, financial advisors have been the voice of optimism, encouraging their clients that if they stay in risky assets, such as equities, they will eventually have superior returns. However, this time around, the AAA debt rating of the United States being downgraded was enough for advisors to look for cover as well. Additionally, as baby boomers begin to retire (at least those who can afford to) allocations naturally turn more defensive and put more money into bonds and less in stocks.
That being said, I think the current shift is cyclical in nature. If people's homes were worth more, they would likely feel more confident investing in stocks, however, without the safety of home equity, people are almost forced to take a more cautious view on investing. If and when home prices come back, and if and when the United States deficit is sustainably under 5% again, investors should have enough confidence to come back into the market and invest.
PN: I don't believe that gold is a hedge in all kinds of uncertain markets. The types of uncertainties investors face today are related to the value of currency and the fiscal stability of sovereign governments. In my opinion, the primary function of gold is as a doomsday hedge. Ownership of tangible gold provides some comfort to those who don't believe there is enough political will to solve today's mounting budget and monetary issues. While I have to believe the Federal Reserve of the United States was well intentioned when it chose to leave interest rates at 0% for a prolonged period of time and engage in multiple rounds of quantitative easing, these practices brought greater instability into the homes of average people. Many people save today and do not put their life savings into the stock market. With interest rates at zero and the news constantly harping on how the U.S. is in serious fiscal trouble, it is easy for people to feel a greater level of safety by having a portion of their savings in physical gold. I think the year-to-year appreciation in gold is significantly less important than the security it provides in the case of fiscal calamity. While the fund doesn't own any physical gold, I personally have a small portion of my savings in it.
PN: There would likely be a sharp, short-term spike in oil prices if any situation in the Middle East got out of hand. However, as has recently been in the headlines, the United States has become a net exporter of oil products. In the case that there was a literal oil shortage, it appears that the United States could pull levers so that the effect of any short-term shortage would be minimized. While this would make global markets more volatile in the short term, the long-term impact would likely be minimal. Global geopolitical events are always something that we factor in to our overall portfolio strategy. The potential of such events are looked at in relation to valuation multiples present in the equity markets. If we see that PE multiples are exuberantly high, not pricing in a real possibility of geopolitical instability, the fund will move to more liquid equities, lower net exposure and increase portfolio activity. If the market is generally inexpensive and over-discounting risk (as was the case after the August swoon), we move to small- and mid-cap stocks and increased our risk profile to catch the upside potential of any ensuing rally.
PN: Normally, I would argue that election-year politics will lead to a prolonged period of volatility in 2012. However, I think the country has seen, and is getting used to, the increased politicization of the United States economy both in Congress and in the GOP primaries. In Congress, the Republican argument for their bills is that President Obama's policies have failed to date, so why would we continue to spend trillions of dollars on failed economic policy? The Democrats argue that not only will a reduction in any social benefits be bad for society's members, but it will also bring down GDP growth.
Concerning the GOP primaries, I think that when the debates started in September the candidates took advantage of the fact that the US was recently downgraded to launch attacks on the current President's economic policies. While the politics are for the people to decide, the constant talking down of the United States economy was a significant hurdle for investor and consumer confidence in September and October. As time bore out, though, people have gotten used to the rhetoric. I doubt that going into 2012, there is any new negative news that isn't already baked into the market, especially if the unemployment rate remains below 9% and continues to improve. As a result, election year 2012 has not led us to change our positioning.
PN: Since the recession started over four years ago, there has been inflation and deflation simultaneously. While the price of some commodities including oil are up over 20%, stocks and home prices have fallen more than 20%. The cost of healthcare and secondary education have continued to increase throughout the recession, while savings rates are at record low levels. It's not difficult to see that the government has had its hand in most of these items and it has resulted in negative consequences for its people. Many, including myself, partially attribute the higher price of oil to an easy money policy. Falling home prices reflect the consequences of overly aggressive government subsidies, in the form of Fannie Mae, Freddie Mac and the Federal Housing Administration, enabling people to purchase homes who could not otherwise afford them, which resulted in a housing bubble. A high percentage of student loans issues over the past few years have been backed by Sallie Mae, a government sponsored enterprise. Finally, nearly 50% of healthcare in the United States is paid for by Medicare, Medicaid and the department of Veterans Affairs.
With this in mind, when we think about whether there will be inflation or deflation going forward, it relies in large part on what extent the government will continue to support these various industries. It appears that easy money is a long-term policy, so we shouldn't expect oil prices to retreat. The government continues to back most home loans. As a result, we should anticipate that at some point, there will be a rebound in housing as the government has created a market for its loans. If the government steps away from student loans, interest rates on these loans would likely skyrocket, and no administration wants to be responsible for that.
Finally, the government has signed a national health coverage mandate into law for 2014, which will increase both the Medicare and Medicaid rolls. With all of these factors considered, inflation is the likely outcome going forward. Whether Republican or Democrat, the basic pool of money available for these programs will likely remain robust and the government will continue to print money.
The question now is will this inflation lead to growth? Over the past few years, it can be argued that if it were not for government spending, the US would not have experienced much in the way of GDP growth. With that being said, at the very least, it is likely that the pace in growth in government spending will slow, resulting in a loss of one leg of growth for the economy. What America needs desperately is a recovery in home prices and home construction. The latest numbers show that home prices continue to decline. However, the numbers also show a 10% decline in existing home inventory since June. As inventory continues to wind down, a bottom should be created for both prices and new construction.
The golden question is, when will this happen? With a 30-year mortgage rate at 4% and record affordability metrics, it should only be a matter of time before people take the leap and begin purchasing homes again. This would boost the economy tremendously as increased pricing would create equity for the over 60% of families that own homes and additional construction would create jobs in a variety of industries from transportation to mining. Additionally, a boost in home construction would lead to revenue for struggling towns across the country in the form of property taxes. In conclusion, while the United States will continue to face headwinds concerning its own fiscal house, pent-up demand and attractive affordability in housing should create a new leg of growth for the United States economy.
Disclosure: I am long CYH, UHS, HMA, CBM, CMED, and am short THC, SRCL.
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