Large Cap Commentary – February 2010
There are periods in the stock market when companies or sectors rise and rise well beyond what seems to be reasonable. Alan Greenspan’s famous ‘irrational exuberance’ comment comes to mind. Mr. Greenspan said that in May 1999. He was right. The problem was that he was right a year and a half before the market fell. That is a long time for the average investor to wait. Even institutional consultants would become a bit nervous in the face of eighteen months of underperformance that heeded Mr. Greenspan’s advice. For us it highlights the value of a process and the sometimes fickle nature of the markets.
At Argent, we use the same process today that we did at our beginning over a decade ago. Like Mr. Greenspan, at the end of the 1990s we had a hard time justifying the risk reward ratio of many leading stocks, especially those in the Information Technology sector. Argent, much like Mr. Greenspan, took a fair amount of flak as the tech sector continued to march upward and Argent’s portfolio lagged. For Argent, the issue was not whether we were right or wrong. The issue was the upside versus downside risk in the sector. If the tech world continued to grow at 50%+ per year, the stocks would continue to rise but even that upside was limited by extreme valuations. If that did not occur, the downside risk looked considerable.
Moving forward to today, Argent continues to focus on companies that are executing, but where the growth potential is not fully embeded into the price of the stock. One area where many companies exhibit this positive risk/reward tradeoff is Healthcare. For Argent, Healthcare is a natural ‘go to’ area. Inherently, there is growth in Healthcare, especially as we baby boomers age. The sector also has high barriers to entry, implying sustainable returns above the cost of capital. Currently, there are a few externalities that we believe have encouraged investors to underappreciate the growth potential of many of these companies. The first and most obvious is what is taking place in Washington. Like the early 1990s, Healthcare is a hot topic and the expectation for growth and profits for the sector have been reduced. That is a possible outcome of the Healthcare reform process. Another current depressant is that hospital endowments are not as flush as the recent past. Endowments supplement hospital income and provide support for capital spending projects. It is possible that the capital spending for hospitals remains subdued for the foreseeable future.
When we look at the valuation of many of the stocks in the Healthcare sector, we believe that the market is embedding these negative scenarios. So we ask ourselves, ‘What if…?’ and, ‘How badly do we get hurt…?’, running scenario analyses in order to gauge the potential upside for names relative to downside. Recently, with that analytical framework, we added Varian Medical (VAR) to our portfolio. VAR is an equipment maker in radiation oncology. Its leadership position is growing and VAR’s technology and installed base create a defensible competitive advantage. VAR, like many Healthcare equipment makers, sold off due to concerns over capital expenditures (CAPEX) spending by hospitals and clinics, combined by concerns over reimbursement rates. At Argent, we are intrigued.
As a part of our research process, Argent began to talk to real world contacts involved in both hospital CAPEX spending as well as oncology. In a conversation with a COO of a major hospital, we were told that VAR’s products offered the hospital a good return on their capital and as such would be more protected when CAPEX cuts are made. Additionally, we spoke with a radiation oncologist, one of our Main Street Contacts, who was able to confirm VAR’s growing market share. Finally, in its most recent quarter, VAR reported better than expected earnings and raised guidance for the year, muting concerns over hospital CAPEX pressures. The positive growth trends, positive Main Street feedback, and favorable valuation conspire to create what we at Argent feel are favorable odds for our clients.
To be sure, the outcome for Healthcare is unclear. For some investors that creates fear. For Argent, we think it creates opportunity, allowing us to find truly great companies selling at depressed valuations. With that as a backdrop, we believe we have improved the characteristics of our client’s portfolios for the next three to five years.
As always, we appreciate your interest in Argent Capital Management and hope you will mention our name to others. If you have any questions or comments, please visit us at www.argentcapital.com.
Senior Portfolio Manager