Large Cap Commentary – August 2014
Over Argent’s sixteen years of business there have been several periods and types of investment controversies including the .coms, China infrastructure plays and mortgage-backed securities, to name a few. The most recent controversy attracting headlines is “tax inversion”. Several U.S.-based firms have re-domiciled their headquarters overseas in order to garner a lower corporate tax rate. Opponents of inversion argue that the move is un-American. Proponents claim that corporations, like any other individual, have the right to seek the lowest lawful tax structure.
As you can imagine, politics is not a main consideration for choosing stocks at Argent. Instead, we seek to identify a fundamental and sustainable change in a company’s operations. We then compare that change to the company’s current valuation. We become interested when a company is experiencing a fundamental positive change which is not yet reflected in its valuation. For us, “tax inversion” has recently come to play within this desired scenario. Recently, we have added companies realizing the benefits of a lower tax structure as well as those we thought likely to pursue the strategy to our portfolio.
A prime example is Endo International (ENDP). ENDP recently named Rajiv De Silva as CEO in an effort to help the company’s execution. Prior to his employment at ENDP, De Silva was the Chief Operating Officer at Valeant Pharmaceuticals (VRX) and assisted in the significant growth of the company. VRX basically wrote the playbook on tax inversion strategies with its acquisition of Biovail in 2011, a Canadian pharmaceutical company. When De Silva was named CEO of ENDP, we asked ourselves whether he could employ a similar and successful plan. Our analysis indicated that if De Silva were to implement such a change at ENDP, the company would realize a substantial benefit to earnings, an outcome that was not reflected in ENDP’s valuation. As such, we believed the potential change (tax inversion) for ENDP represented favorable odds for our clients and we added the stock to our portfolio in mid-2013. ENDP was successful and acquired another pharmaceutical company with a tax-base in Ireland. This lowered ENDP’s corporate taxes and freed up cash flow. ENDP’s stock rose 15% on the day the acquisition was announced.
A second example of the use of tax inversion is St. Louis-based Mallinckrodt Pharmaceuticals (MNK). MNK was originally spun-off out of Covidien (COV) which had re-domiciled itself in Ireland, thereby realizing a lower corporate tax rate. As MNK was initially a part of COV, upon its spin-off, MNK also assumed a lowered Irish tax rate. We applied the same analysis for MNK as we did for ENDP, asking ourselves whether MNK could use its lower tax base to make accretive acquisitions. Our research indicated this scenario was plausible and not yet reflected in MNK’s valuation. With this favorable, fundamental change occurring, we added MNK to our portfolio in late 2013. Thus far, our thesis has proved correct. MNK has acquired both Cadence Pharmaceuticals as well as Questcor Pharmaceuticals and the stock is up approximately 67% since its first acquisition.
In closing, Argent does not target controversy when we research companies. We will leave the controversy to politicians. Rather, we look for catalysts within a company which we believe will drive higher sales, greater profits or increased earnings. Both ENDP and MNK have been positive contributors to the Argent Large Cap portfolio. The fundamental change – in this case, a lower tax rate – allowed each company to pursue accretive acquisitions to benefit shareholders. As always, we appreciate your interest in Argent Capital Management.
Ken Crawford , Senior Portfolio Manager
Views expressed herein represent the opinion of the portfolio manager as of the date above and are subject to change. Past performance is no guarantee of future results. The information provided in this report should not be considered a recommendation to purchase or sell any particular security. You should not assume that investments in any securities were or will be profitable. A list of stocks recommended by Argent in the previous year is available upon request.