Oct 11, 2016

Dean Orrico and Richard Evans' Top Picks: October 11, 2016

BNN Bloomberg

Dean Orrico and Richard Evans , BNN

Dean Orrico, president and chief investment officer at Middlefield Capital and Richard Evans, head of healthcare practice at SSR

Focus: Healthcare stocks
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MARKET OUTLOOK
Since we’re in a relatively low-growth world in developed economies, we believe interest rates will remain low for the foreseeable future. Even if the Federal Reserve doesn’t increase rates in December, we believe there’s a high likelihood that they do raise at least once over the next six to nine months. This type of macro environment favours equities over fixed income with an advantage to dividend-paying stocks. As a result, we believe pipeline and power producers along with REITs are well positioned in the current market. Given the pullback in REITs over the past few weeks, we believe they are very attractively valued.

In light of all the political rhetoric surrounding drug pricing in the U.S., healthcare equities, which had been perennial outperformers on an absolute and risk-adjusted basis, have pulled back. As a result, healthcare stocks are currently trading at a discount to the broader market with greater earnings growth potential. We believe this has created a very attractive investment entry point for traditional pharmaceutical companies. In addition, we work closely with Dr. Richard Evans and his team at SSR to identify those pharmaceutical companies who have significant hidden value in their drug pipelines. The methodology utilized by Dr. Evans is proprietary to his firm and has been developed over many years as a result of his experience at Roche and as the pharmaceuticals analyst at Sanford Bernstein, where he was ranked number one in the country.

Since we believe energy prices bottomed in February of this year, we have gradually increased our energy exposure over the past several months. The current talk around an OPEC production freeze has supported this view. We are focused on dividend-paying energy equities that are low-cost operators. The recent surge in natural gas prices is also driving gas-weighted equities higher.

TOP PICKS

MEDTRONIC (MDT.N)
Medtronic is a global leader in medical technology product sales, with one of the strongest management teams in the industry. The company is at the beginning of an exciting new product cycle which will drive growth. Over the long-term, management has guided to mid-single-digit revenue growth and double-digit EPS growth. We expect the company to grow earnings at a double-digit rate through 2020, driven in part by the rapidly expanding TAVR market. For 2017, management is targeting 130 to 200 basis points of margin improvement. Management expects the company to generate $40 billion of free cash flow over the next five years, half of which will be returned to shareholders through dividends and buybacks, and half used for M&A, debt reduction and financial flexibility. The stock trades at a very reasonable valuation of 17.8x 2017 EPS, a slight discount to its large cap peers, and pays an attractive 2 per cent dividend yield.

ROCHE (ROG.VTX) (RHHBY-5)
Roche is a global pharmaceutical company focused on oncology. The company has one of the largest R&D budgets in the industry, both in absolute and relative terms, and has an exceptional long-term drug pipeline, which SSR believes is undervalued by the equity market. In the near-term, the company expects to grow earnings at mid-single digits. In part due to slower near-term growth, the stock trades at 15x 2017 EPS, a discount to European pharma peers, and pays a very attractive 3.4 per cent dividend. The company has increased its dividend for 29 consecutive years, and management expects this trend to continue.

RITE AID (RAD.N)
The company is being acquired by Walgreens for $9 per share in an all-cash transaction. Based on U.S. federal proximity standards, the pharmacy industry is very over-supplied and requires consolidation going forward. The oversupply of pharmacies was due, in part, to the growth in dispensing margins, which were the fastest-growing segment of any retailer for the past decade and which are now in decline. Based on established federal guidelines, we believe that the combined entity would need to divest between 400 to 500 of the 8,200 stores acquired to win approval from the regulators. Shortly after the transaction was announced, Walgreens’ management had stated they were willing to divest up to 1,000 stores, so we believe that management is willing to be very cooperative with regulators to get the deal approved. The past 12 months has seen a record number of M&A deals fall apart in the United States, causing deals to trade at very wide spreads. We believe the current spread of over 20 per cent is very attractive, and offers very compelling risk/reward as the transaction is expected to close in the coming months.

Disclosure	Personal	Family	Portfolio/Fund
MDT	N	N	Y
ROG	N	N	Y
RAD	N	N	Y

FUND PROFILE: MIDDLEFIELD GLOBAL HEALTHCARE DIVIDEND FUND
Middlefield Global Healthcare Dividend Fund is listed on the Toronto Stock Exchange under the symbol GHC_u. It is the largest actively managed healthcare fund in Canada with a current yield of approximately 4.5 per cent.

The Fund is well diversified geographically with approximately 65 per cent invested in U.S. companies and approximately 35 per cent in other developed markets. The Fund does not invest in companies domiciled in emerging markets. The Fund is also well diversified by asset class with exposure to traditional pharmaceutical companies, medical device companies, pharmacy retail players and seniors’ housing REITs. The Fund does not invest in biotech companies.

PERFORMANCE AS OF SEPTEMBER 31, 2016: