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Equity Perspectives

How Lord Abbett analysts scope out world-changing trends and shape investment decisions.        

 

 

In Brief

  • Among the investment themes that emerged during Lord Abbett’s recent research presentations were the transformative innovation and growth opportunities in technology, Internet, and media stocks; rapid advances of new therapies in the biotech and pharmaceutical sectors; winners and losers among U.S. consumer stocks; and value and growth opportunities in the sometimes underappreciated financials sector.
  • Tech is going through a once-in-a-decade disruption phase, driven by the cloud; faster, cheaper, and more pervasive computing; greater bandwidth; the global mobile app economy; the growing scale and influence of hyper-scale companies such as Google and Amazon; and the emergence of open-standard software.
  • Relentless innovation also figures prominently in the outlook for the pharmaceuticals and biotech sectors, as R&D productivity is accelerating, resulting in a growing number of drug approvals in recent years.
  • Of the five consumer staples sectors he covers, Lord Abbett Research Analyst John McMillin highlighted beverages (which helped propel the consumer staples sector last year).
  • In the consumer discretionary sector, Lord Abbett Research Analyst Helen Woronoff focused on innovative leaders in the “fast casual” restaurant business. Lord Abbett Research Analyst Chris Wiggins assessed the investment prospects for a major motorcycle manufacturer versus car manufacturers.
  • With major banks mired in rising litigation costs, Lord Abbett Research Analyst Greg Wachsman had a more positive view on so-called super-regional banks.

 

You can tell a lot about an active manager by the research that guides his decisions to buy, sell, or hold securities. If that research is collaborative and hews to a rigorous discipline that explores every salient angle, portfolios may respond to changing market and industry conditions faster than passive index funds and exchange-traded funds. If the research is also independent—building an investment thesis around solid fundamental, technical, quantitative, and economic metrics that sometimes counter overly bullish (or conflicted) Wall Street forecasts—the potential to add value may be considerable, notwithstanding the risk of negative surprises dampening performance.

So it goes at Lord Abbett, where analysts, portfolio managers (some of them former analysts), risk management, and quantitative research experts confer regularly to weigh in on the strengths, weaknesses, opportunities, and threats facing companies and sectors. Come January, analysts tally what worked in the preceding time period, what didn’t, which stocks look attractive and unattractive in the next six to 12 months, and how portfolios are exposed to various investment themes.

Among the investment themes that emerged in Lord Abbett’s recent research presentations were the transformative innovation and growth opportunities in technology, Internet, and media stocks; rapid advances of new therapies in the biotech and pharmaceutical sectors; winners and losers among U.S. consumer stocks; and value and growth opportunities in the sometimes underappreciated financials sector.

The Cloud and Big Data Analytics Help High Performance Computing Go Mainstream  
From listening to Lord Abbett Technology Research Analyst Eric Ghernati, it’s easy to see why the technology sector figures so prominently in various investment strategies. In his presentation, Ghernati explained how tech is going through a once-in-a-decade disruption phase, driven by: the cloud; faster, cheaper and more pervasive computing; greater bandwidth; the global mobile app economy; the growing scale and influence of hyper-scale companies such as Google and Amazon; and the emergence of open standard software.

“Web 3.0 companies have found a way to disrupt so many industries because they put in place smart and high-performance infrastructure, and have found a way to manipulate and extract intelligence from the vast amounts of data they had access to, and have used that to their advantage,” said Ghernati. (See Figure 1.) “As a result, companies in the old economy need to think of IT as a strategic weapon to sustain their competitive advantage, lest they be left behind. They need to deploy ‘Big Data’ and high-performance computing.”

While some old-line tech companies have been slow to transition to a Web 3.0 ecosphere, given legacy systems or organizational obstacles to innovation, Ghernati favors companies that have been able to innovate the fastest and expand their markets. 

In semiconductors, this level of innovation has translated to companies that have enjoyed rapid penetration of wired and wireless communications in the home, office, and mobile environments, intelligent networking, automotive electronics, enterprise storage, and industrial applications.

Ghernati has been particularly impressed with a company that has been generally underappreciated by Wall Street but appears well positioned to meet the growing demand for enterprise security, next-generation wireless infrastructure, data-center networking, software-defined networking, virtualization, and high-performance computing.    

In tech hardware, Ghernati reiterated his positive view on the leaders in network architecture key to the growth of the World Wide Web so far. The same goes for software providers that have been instrumental in the proliferation of the cloud, which will be explored further in the next part of this series.

 

Figure 1. Web 3.0 Is the Product Cycle of the Decade
New applications that combine the cloud and Big Data have transformed industries on a global scale.Source: Lord Abbett.  

 

Media, Internet and Cable
Just as traffic on the information superhighway has accelerated at a phenomenal pace, so have the challenges faced by media, Internet, and cable companies—but Lord Abbett Research Analyst So Young Lee said diversifying content platforms should drive some compelling investment opportunities in those sectors in 2015.

Among the more salient trends outlined in her presentation, Lee cited declining viewership in television in the 18–54 age bracket. While total media consumption is up, audiences are fragmenting more than ever, as they spend more time on smartphones (see Chart 1), which underscores the opportunities to provide content people want to watch anytime, anywhere, any place on their favorite screens, and the challenges to attract advertising on those programs. “There is quite a mismatch between time spent watching video and the amount of ad dollars spent, especially when it comes to content on mobile devices,” said Lee.  

One of the big questions in the sector is whether Internet and TV advertising expenditures will intersect.  While the gap is quite large (see Chart 2), some experts don’t think it could happen in the next one or two years. But Lee thinks that outlook is overly pessimistic.

 

Chart 1. Overall Media Consumption Is Increasing, Especially on Smartphones
Average time spent per adult (18+) per daySource: The Nielsen Company.

 

Chart 2. Time Spent and Ad Dollar Mismatch—The Mobile Opportunity
Internet advertising also has a long way to go to catch up with TV

Source: Mary Meeker, KPCB Internet Trends.

 

Taking Healthcare’s Temperature
Relentless innovation also figured prominently during Lord Abbett Research Analyst Lavina Talukdar’s discussion of healthcare therapeutics, which comprises a significant chunk of national healthcare expenditures each year. (See Chart 3.) After all, R&D productivity in the pharmaceuticals and biotech sectors has accelerated, resulting in a growing number of drug approvals per R&D dollar and a growing number of drug approvals in recent years. More efficacious and convenient drugs, in turn, aim to and have made some old-line drugs obsolescent faster.   

One catalyst for this trend was the flood of valuable information since the human genome was sequenced in 2003; another was the increasing level of cooperation in medical research transformed by advanced diagnostic, testing, and imaging technologies—all of which have helped the pharmaceutical and biotech sectors reach a critical inflection point, where new breakthrough drugs can reach the market faster than ever.

“We are in the midst of a major reacceleration of new drugs coming onto the market,” said Talukdar. Her view on stock selection was simple: “Be selective.”

One approach Talukdar recommended was to look for stocks with low multiples due to controversy, but with the potential for strong, sustainable revenue and earnings growth nonetheless.    

Talukdar also cited five other biotech companies whose innovation have the potential to clear critical hurdles in clinical trials and, in turn, drive increases in out-year earnings estimates. These opportunities seem generally underappreciated by the market and pass her selection criteria, while other stocks seem fairly priced for the stage of development they are in—all the more reason to be selective, she added.  

As for the pharma sector, Talukdar explored several major companies with the potential to grow earnings based on their core competency in treating certain diseases and from accelerated new-product launches.  She also paid particular attention to companies that are developing drugs for cancer, Alzheimer’s disease, and a novel approach to tackling high cholesterol.  

“Companies that are first to market with best-in-class products have a better chance to become incumbents,” Talukdar added. By “best-in-class,” she was referring specifically to the prospects in immunotherapy (which can help improve a patient’s defenses against a variety of diseases), CD4K (a cell cycle regulator that can inhibit proliferation and growth of some tumor cell types), and hepatitis C (which affects an estimated 3.2 million people in the United States and is the most common blood-borne chronic infection in the nation).   

Another disruptive force in the battle against serious diseases is the maturation of so-called RNA1 technologies that combine the fields of biochemistry, chemistry, molecular biology, cell biology, physics, nanotechnology, and bioinformatics. Simply put, RNA conveys genetic information from DNA2 and plays a critical role in the formation of proteins that regulate myriad bodily functions.

Turning to the specialty pharmaceutical sector, which generally refers to niche players, mergers and acquisitions (M&A) remained a theme for some companies, Talukdar added. Her advice was to look at companies that can participate in M&A-driven activity, as long as their larger size doesn’t dampen their overall growth prospects.

 

Chart 3. Where the Nation’s Health Dollars ($2.9 Trillion) Went in 2013
Breakdown in healthcare expenditures by broadest sectors

Source: Centers for Medicare and Medicaid Services.

 

Hospitals, Managed Care, and Devices
With an office right next to Talukdar, Lord Abbett Research Analyst Devesh Karandikar has plenty of opportunity to compare notes on healthcare trends that affect their respective sectors. While decreased uncertainty about healthcare reform pushed price-to-earnings (P/E) multiples of some companies in Talukdar’s universe close to peak valuations, Karandikar’s healthcare services and medical devices sector has been wrestling with cost containment and efficiency in the face of increasing pressure on reimbursement from insurers.

Among healthcare providers, cost of care reduction has been episodic, he said, but there has been some progress in terms of remote patient monitoring, alternative sites of care, and patient care coordination. Doctors continue to move from solo practices to group practices or larger hospitals. Hospitals continue to move away from costly in-patient care by diversifying their out-patient and ancillary services. And multifaceted clinics (sometimes known as “doc-in-a-box”) have sprung up in various shopping districts to appeal to cost-conscious patients.  

Among suppliers such as pharmaceutical distributors, pharmacy benefit managers, and device manufacturers, it may well take more M&A and broader offerings to achieve necessary economies of scale and mitigate pricing pressure, Karandikar added. One notable move in that direction was a major managed care company’s creation of a platform devoted to helping improve the healthcare system itself, including care delivery and clinical outcomes of patients. 

Although the stock market has priced in greatly expanded coverage under healthcare reform, the next phase of cost containment at both the industry and government level remains a wild card, and some analysts are hesistant to recommend ways to play that theme until the policy landscape becomes clearer. 

In any event, Karandikar commented on some of the strongest players in the drug-supply chain. One company he cited was benefiting from accelerating revenue growth, savvy capital deployment, and diversification in the medical/surgical space. In contrast, he also cited a second enterprise that not only has expanded its market share but also has made considerable progress transforming its business strategy.

Clearly politics will weigh on healthcare sector as the 2016 presidential election draws closer, but in managed care, some analysts believe two major players remain well positioned. One is considered a market leader, with diversified business model and growth in non-regulated businesses. The other has seen revenue growth driven by new markets, especially after diversifying into specialty services.  

Hospitals, meanwhile, have benefited from an improving economy, an influx of new patients under healthcare reform, and stronger operating profitability. And Karandikar expected both revenue and patient volume to increase in 2015. If so, some market players believe that may benefit a company with the most leverage to a rebound in such volumes, as well as Medicaid expansion in one populous state; a giant hospital operator that is known to pay special dividends or buy back stock and has plenty of cash to do either; and a kidney care specialist that is poised to consolidate more physician practices.

Life Sciences and Beyond
Batting next for the healthcare team is Lord Abbett Research Analyst Heidi Lawrence, whose area of expertise comprises life sciences tools, diagnostics, laboratories, hospital staffing as well as veterinary and dental services.

Commenting on the life sciences tools and diagnostics, Lawrence said M&A speculation was generally supporting valuations in that sector, but she advised looking at such companies based on select capital deployment and secular growth stories. Among the candidates that generally embody those traits and characteristics:

  • a well-diversified company that had a high exposure to macro trends in the U.S. economy and is a consolidator;
  • a global player whose potential for margin expansion, as well as recovery in China, was generally underappreciated;
  • a major supplier of precision instruments and services with an opportunity to leverage its service and pricing advantage and expand its sales force; and
  • a powerhouse in genomic testing and research that is transforming the way doctors diagnose various maladies.

“Disruptive tests toward a personalized approach to medicine have entered the market, fueled by reduced cost of genomic sequencing,” said Lawrence. “And next-generation sequencing should not only permit the use of new clinical applications that were not previously feasible but also save the healthcare system money.”

By new clinical applications, Lawrence was referring to a liquid biopsy that lowers the number of traditional biopsies; non-invasive prenatal testing that improves the detection of Down syndrome and monitors drug resistance; and hereditary risk assessment like tests that have led some patients to have a preventative surgery given their genetic history.

Continued advances in genomic sequencing is leading to significant M&A at hefty valuations, as companies scramble to defend their businesses and build new markets, Lawrence added.

As for the physician staffing sector, Lawrence believes hospitals needing to streamline their staffing costs and increase their quality of care would continue to drive consolidation and growth—and, in turn, earnings—in the fragmented industry. That, in turn, may drive interest in some of the largest providers of outsourced physician staffing solutions for hospitals in the United States.

A Toast to Beverages
Of the five consumer staples sectors he covers, Lord Abbett Research Analyst John McMillin had plenty to say about the potential investment opportunities in beverages, which helped the consumer staples sector last year. While two companies appeared to be particularly well positioned going forward, McMillin said another beverage maker may be behind the curve in catering to the more health-conscious millennial generation. But he noted valuations for multinationals are historically cheap and that that particular company is entering a “self-help” phase where cost cutting and mergers and acquisitions could be rewarding. 

“Beverages have the most to gain from the current macroeconomic environment,” McMillin said, citing the following factors:

  • Tap water represents 27% of beverage consumption, and that percentage changes with the economy.
  • Lower gasoline prices give consumers more money at the pump, and that often converts to beverage purchase.
  • Technology is enhancing industry product mix, as 16% of all coffee consumption is now single-serve pods.
  • A new single-serve cold beverage machine from one industry leader offers consumers the ability to stop carrying home heavy beverages.
  • One beverage maker’s new line extension is all natural, which should appeal to health-conscious millennials, in particular.

As for M&A (a strong trend in 2014, as depicted in Chart 4), McMillin assessed which major beverage company might buy another colossus that has underperformed in recent years, which food supplier might be acquired by a global giant, which mergers might not happen, and which multinational might succumb to activist pressure and spin off a sizable division to maximize shareholder value.

 

Chart 4. Investment Bankers Busy in Consumer
Number of M&A deals worth more than $1 billion (1996–2014)  

Source: Standard & Poor’s, Compusat, FactSet, RBC Capital Markets estimates; note: 2014 annualized based on the run-rate of 269 deals as of October 31, 2014.

 

Looking abroad, McMillin found that international consumer staples companies were trading at significant discount to their U.S. counterparts in terms of P/E multiples estimates for the next 12 months.

Restaurants, Cars, and Motorcycles
In the consumer discretionary sector, Lord Abbett Research Analyst Helen Woronoff dwelled on innovative leaders in the “fast casual” restaurant business. Not to be confused with “quick-serve” restaurants best known for fatty foods, sugary drinks, and drive-in windows, fast casual restaurants have become the fastest growing segment of the restaurant business, with highly customizable menu offerings, affordable prices, and generally healthier ingredients, which have proven quite popular with younger customers. 

Depending on a portfolio’s particular investment style (growth, value, etc.) Woronoff suggested two ways to play the restaurant sector. The first was to identify stocks best positioned to rapidly respond to changing consumer preferences, which are widening the gap between winners and losers. The second was to identify value opportunities where the market is too pessimistic. “Avoid secular losers whose brand positioning is structurally challenged,” she advised—a reference to once-iconic fast food chains that have been unable or unwilling to revamp their business strategies. A number of those losers can be found within crowded categories such as burger fast food and casual dining. (See Chart 5.)

 

Chart 5. Quick-Serve Restaurants (QSR) Still Comprise Half the U.S. Restaurant Industry
“Fast casual” has a small share of the market, but is the fastest growing segment.

Source: Euromonitor, 2012. MCD refers to McDonald’s.

 

While lower gasoline prices may drive more customers to restaurants this year, automobile manufacturers are looking at a bumpy road. “Car sales have nearly peaked on a seasonally adjusted basis, and pricing pressures are picking up,” said Lord Abbett Research Analyst Chris Wiggins. 

Among the other reasons to avoid auto manufacturers, Wiggins cited a growing supply of off-lease vehicles, which may pressure residual values and impact vehicle affordability; risk of tightening credit conditions; original equipment manufacturers’ (OEM) capacity expansion, and the negative impact on margins; a weaker yen, which increases the competitiveness of the Japanese; peaking product refresh rates, which generally leads to higher OEM incentive spending; luxury competition, which has introduced more competitive, lower-priced models; increasing structural content costs; and upcoming United Auto Workers negotiations, which likely will end up with higher wage rates.   

All of this explains why Wiggins suggested looking into a major motorcycle manufacturer over car manufacturers, not to mention a certain services company and automotive parts supplier that appeared well positioned in this environment.

Financials: The Good, the Bad, and the Ugly
“In the middle of difficulty lies opportunity,” Albert Einstein once said. That thought certainly resonated during the presentation given by Lord Abbett Research Analyst Greg Wachsman on the financial services sector, which arguably has endured more negative publicity than during the Great Depression. According to Boston Consulting Group (BCG), litigation, penalties, and fines cost U.S. and European banks nearly $65 billion last year, about 40% greater than 2013 (the previous high), and such expenses could continue in the years ahead. “Litigation cost has become a part of the cost of doing business,” said BCG principal Ingmar Broemstrup.3

Even so, some value investors have maintained their positions in the strongest major banks figuring the worst has passed and dividend payouts are poised to rise in the next year. But Wachsman had a more positive view on so-called super-regional banks, which generally are defined as a mid-sized bank that has a significant presence in a geographical region across multiple states. 

“Super-regionals have outperformed the rest of [our] bank coverage, given their cheap valuation and strong fundamentals, and the valuations remain attractive, unlike a number of regional banks in our universe, where the valuations have gotten rich,” Wachsman said. Also worth consideration, in his view, were two specialty finance companies that stood to benefit from improving capital markets.

 

Chart 6. Legal Troubles Have Hammered the Largest Banks Since the Financial Crisis
Total litigation costs, fines, and penalties paid to U.S. and European officials

Source: Boston Consulting Group, The Wall Street Journal

 

The Bottom Line
Working as a research analyst is a great training ground to become a portfolio manager and a number of portfolio managers at Lord Abbett have done just that. Some portfolio managers also are the primary analyst on certain sectors and, on international strategies, regions as well.

Whatever the credentials of analysts—some have multiple degrees or designations—they typically wear many hats. Aside from monitoring critical factors in multiple sectors and industries, forecasting company earnings and deriving price targets, they must originate fresh ideas—or “variant perceptions,” as they’re called at Lord Abbett—to attempt to beat the market. They must be alert to red flags, as well as red herrings, and constantly attuned to buy and sell signals. If a stock is grossly undervalued versus consensus estimates, or for that matter overvalued for some overlooked reason, sharp analysts will march into a portfolio manager’s office to convey such strong conviction.  

As James J. Valentine, founder of AnalystSolutions, puts it, “The key to generating alpha4 is having a more accurate view about a future stock price than the market. This can only be done on a consistent basis if the analyst has an edge over the market in one of three areas: a financial forecast superior to the market; valuation methodology or valuation multiple superior to the market; and a forecast of investor sentiment that is superior to the market, [since] sentiment, void of any fundamental changes, is often the only thing that moves a stock or market in the short term.”5

 

1 RNA, or ribonucleic acid, is a molecule similar to DNA (deoxyribonucleic acid). Unlike DNA, RNA is single-stranded. An RNA strand has a backbone made of alternating sugar (ribose) and phosphate groups.  Attached to each sugar is one of four bases: adenine (A), uracil (U), cytosine (C), or guanine (G). Different types of RNA exist in the cell: messenger RNA (mRNA), ribosomal RNA (rRNA), and transfer RNA (tRNA). More recently, some small RNAs have been found to be involved in regulating gene expression. (Source: National Human Genome Research Institute.)
2 DNA, or deoxyribonucleic acid, is the chemical name for the molecule that carries genetic instructions in all living things. The DNA molecule consists of two strands that wind around one another to form a shape known as a double helix. Each strand has a backbone made of alternating sugar (deoxyribose) and phosphate groups. Attached to each sugar is one of four bases: adenine (A), cytosine (C), guanine (G), and thymine (T). The two strands are held together by bonds between the bases; adenine bonds with thymine, and cytosine bonds with guanine. The sequence of the bases along the backbones serves as instructions for assembling protein and RNA molecules. (Source: National Human Genome Research Institute.)
3James Sterngold, “For Banks, 2014 Was a Year of Big Penalties,” The Wall Street Journal, December 30, 2014.
4 Alpha is the difference between a fund's expected returns based on its beta and its actual returns. Some investors interpret that as the value that a portfolio manager adds, above and beyond a relevant index's risk/reward profile.
5 James J. Valentine, Best Practices for Equity Research Analysts—Essentials for Buy-Side and Sell-Side Analysts (McGraw Hill, 2011).

 

RESEARCH IN ACTION BLOGS

Lord Abbett analysts assess the trends and opportunities in various sectors in a series of blogs:

▪ Why Web 3.0 is the Product Cycle of the Decade 
▪ Chasing Eyeballs 
▪ Riding Herd on Changing Consumer Patterns

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