cheswold lane asset management, llc

CHESWOLD LANE ASSET MANAGEMENT, LLC
100 FRONT STREET, SUITE 960
WEST CONSHOHOCKEN, PA 19428
PHONE 610-940-5330
FAX 610-941-5009
INTERNATIONAL HIGH DIVIDEND STRATEGY
2ND QUARTER 2015
INVESTMENT LETTER
Thank you for your continued interest in Cheswold Lane’s international value equity strategy. During the
second quarter of 2015, our investment strategy’s composite increased 1.58% on a gross basis compared
with a rise of 0.62% in the MSCI EAFE (Morgan Stanley Capital International Europe, Australasia and
Far East Index) including income, net of withholding taxes and expressed in US dollars.
Market Review – 2nd Quarter 2015
The optimism that began the year continued through May until doubts about Greece’s negotiations with
the ECB, IMF, and European Commission began to focus investors’ minds on sovereign debt risks in the
Eurozone again. US dollar based returns for the quarter ended modestly positive in international markets,
though international small cap stocks continued their outperformance from the first quarter to the second.
The US dollar weakened against the Euro and Pound, but strengthened against the Australian dollar and
Japanese Yen, as Asian economic growth fears heightened during the second quarter.
2Q 2015 STOCK MARKET RETURNS %
LARGECAP
USD
Local
SMALLCAP
USD
Local
DevelopedMarkets
S&P500/Russell2000
MSCI‐EAFE
MSCI‐Europex‐UK
MSCI‐UK
MSCI‐JAPAN
MSCI‐AUSTRALIA
0.29%
0.62%
‐0.79%
‐3.00%
‐0.66%
‐6.57%
‐1.82%
‐4.40%
‐4.64%
2.06%
‐3.88%
0.42%
4.16%
2.17%
5.31%
3.16%
‐7.95%
2.26%
‐1.50%
3.53%
5.99%
‐5.30%
0.69%
6.96%
7.56%
‐3.61%
6.04%
0.70%
3.96%
3.99%
‐1.92%
6.03%
4.50%
4.10%
5.78%
‐5.30%
20.30%
4.71%
1.18%
2.80%
‐3.64%
20.29% EmergingMarkets
MSCI‐EmergingMarkets
MSCI‐Brazil
MSCI‐Russia
MSCI‐India
MSCI‐China
Source: MSCI, Frank Russell, S&P
1 China’s stock market experienced significant volatility climbing more than 20% in the first two months of
the quarter before suffering a 15% decline in June. Chinese equity markets have traded in a relatively
detached manner from global equity markets this past year, as Chinese government efforts to boost the
economy have created an equity market bubble. The bubble appears to have burst and the government is
attempting to “manage” the market’s soft landing.
Greece
The January 2015 election of the SYRIZA government in Greece, led by Prime Minister Alexis Tsipras,
was essentially a rejection of the austerity budgets that had been imposed since the 2009 global financial
crisis. The Eurogroup gave the new Greek government a four month budget extension in February.
Towards the end of May, the stark differences between the red lines of the new Greek government and the
objectives of the European Union became clear to all participants, leading to the Greek referendum vote
of July 5th. The fact that the Greek people overwhelmingly rejected the final proposal from the European
Union did not seem to make much of a difference in the final round of negotiations. Despite a lot of
bluster and last minute negotiating, the Greek government accepted the final bailout proposal with only
minor changes. While the long-term outcome of these changes is not clear, the entire EU integration
project has been severely strained.
Unlike the 2010 crisis, this time the Greek debt has been firmly socialized across the EFSF, IMF, ECB,
and Greek Loan Facility (EU). Only a small portion of the debt remains in the hands of investors and
non-Greek banks. As a result, the debate was really a government-to-government transfer, which was
more of a challenge for fiscal donor countries like Germany, Finland and the Netherlands. While a
nominal debt haircut is off the table now, Germany did include a number of potential options for Greece
that would result in a real, significant debt reduction over time.
The bottom line is that the Germans called the Greeks bluff on exiting the Euro and the Greek
government blinked. German Finance Minister, Wolfgang Schaeuble, insisted that dissident behavior not
be rewarded in the monetary union – and he held to his word by offering a “Grexit plan” if the Greek
government didn’t want to get back in line.
2 Capital flows into Europe remain strong, though the run up to the Greek referendum vote reduced the
growth rate noticeably. Fund flows tend to follow performance with a lag so much of the new money in
Europe could be looking for greener pastures over the next year.
Source: Credit Suisse Portfolio Review & Outlook
Performance in the second quarter was positive, driven by a strong rebound in our energy positions. Most
sectors contributed positive selection, with the exception of the consumer discretionary sector – Macau
gaming and Swiss watch companies. With respect to positive stock selection, BG Group was the largest
alpha generator during the quarter. BG Group received an attractive takeover premium from its UK peer,
Royal Dutch Shell. BG was our largest individual energy holding at the time. Other energy stocks,
including Santos Energy, Origin Energy, Saipem, and Technip, all contributed positive alpha during the
quarter.
Cheswold Lane Sector Attribution
2.0%
1.5%
1.0%
0.5%
0.0%
‐0.5%
‐1.0%
‐1.5%
Source: Bloomberg
3 In Asia, Hong Kong-based, Dah Sing Financial’s stock price appears to have been influenced by the
volatility in the Chinese equity market, appreciating 30% through May, before giving back half of the
gains in June. However, the company’s underlying fundamentals remain strong. In fact, Dah Sing’s
Chinese banking subsidiaries have seen improving credit trends in the last six months in contrast to many
mainland Chinese banks. In Japan, Nitto Denko and Daikin Industries also performed well during the
quarter, as the Yen continued its weakening trend, falling from 120 to 125 JPY vs the US dollar in June.
Our biggest underperforming industry in the quarter was the Macau gaming stocks, which continued to
suffer from government policy headwinds – anti corruption/money laundering, anti-smoking, travel
restrictions, etc… We see significant value in these companies especially our primary holdings, Wynn
Macau and MGM China, which have very large hotel/casino property expansions opening in early and
late 2016.
Capacity Increase MGM China and Wynn Macau
Source: Company Data
Of positive note, the Macau government announced in early July an easing of transit visa rules, which
were tightened only last October. Relaxing the transit visa law allows VIP clients to travel to Macau
more often and to stay longer. This is the first positive policy news for the industry in two years. It is
also a very public statement saying that the government wants VIP clients to come back to Macau. The
government also publicly commented that it is willing to consider the installations of smoking lounges in
VIP sections of Macau casinos. The effect would be to reduce the time clients are outside the gaming
rooms, which would increase industry revenues. Why has the Macau government (and Beijing) altered
course? The speculation is that it’s because local government tax receipts, which are derived almost
exclusively from gaming revenues, have declined to a level where Macau no longer has a budget surplus.
Government policy remains a key focal point for investors in Macau; we are watching this closely.
Macau gaming revenues are expected to bottom in the 2nd quarter of 2015 and resume growth in 2016
driven by significant property capacity expansions, a resumption of growth in the Mass market segment
and the lapping of very negative revenue comparables in the VIP gaming segment. Future changes in
government policy and Chinese economic growth forecasts are market “known-unknowns.”
4 Macau Gross Gaming Revenue (GGR) Trend and Forecast
Source: Credit Suisse, Macau Government
The stocks are now down close to 60% from their January 2014 highs, which coincided with peak
industry revenues and cash flows and the start of the government policy crackdown in Macau. Our thesis
is that Macau’s focus is shifting from VIP to Mass Chinese customers, which is a more sustainable and
higher margin business. The transition was always going to be difficult, thereby offering opportunities to
long term value investors; but it has been exasperated by severe government policy changes and a soft
economy. We remain committed to the investment, but selective in adding to our positions until we see
more clear signs of industry and policy bottoming. The stocks will remain volatile until the
fundamentals turn.
Macau Industry Stock Performance and Recent Events
5 Other portfolio holdings of note
We continued to add to Sika AG, a leading manufacturer of specialty construction materials, making it a
top 3 position in the portfolio. This is a high quality Swiss company in the throes of a very public
corporate governance crisis. Six months ago, the company’s founding family (3rd and 4th generation)
entered into an agreement to sell their 16% economic stake, but 53% voting control, to Sika’s larger
French rival, Saint Gobain, for an 80+% premium. This event caused a very sharp drop in the shares of
Sika, as independent shareholders were not included in the deal. In effect, the family usurped the entire
control premium that all shareholders traditionally benefit from when being acquired. This has significant
implications for many Swiss corporations that have family holders with super voting shares – almost all
of which are given special opt-out clauses by their companies; thereby releasing them from Swiss
corporate law which requires any voting control group of more than 30% to make an offer for all of the
company’s shares.
Our investment thesis is that while this moves through the Swiss court system, and ultimately to the Swiss
Supreme Court, there will be a negotiated settlement. The most likely solution is that Sika purchases the
shares from the family at a significant premium (50-60%), but over time (3-5 years), so not to limit Sika’s
financial flexibility – dividend growth and bolt on acquisitions. Saint Gobain will require a consideration
to walk from the deal too. This will most likely take the form of a joint venture structure for the two
companies overlapping businesses in France, and possibly Spain, which would afford significant cost
synergies and reduced competition for Saint Gobain. The shares offer 30-40% appreciation from multiple
expansion and 12% earnings growth per year, while we wait for a resolution. The risk/reward is very
attractive and we think all the parties will want to make a deal before yearend 2015. We know that early
settlement talks have occurred, but not the specific terms as of yet.
Portfolio Holdings – June 30th
The portfolio’s holdings are displayed in the chart above. The width of each column represents the
proportion the sector is of our total portfolio ie. energy and financials are the two largest sectors, and
6 combined represent approximately 30% of the portfolio. The height of the box for each individual
security represents the relative proportion of the security in that sector; for example, Origin Energy is the
largest holding in energy sector and is slightly more than 20% of the energy sector’s weight.
The graph below shows the relative sector weights versus our benchmark. These weights remain
relatively stable from last quarter. One area that has increased is the materials sector due to our growing
position in Sika Ag. On a geographic basis, the portfolio is overweight the UK, Switzerland, Australia
and Hong Kong and underweight Japan and Continental Europe (x-Switz.)
Cheswold Lane Sector Weights
Relative To MSCI EAFE
10.0%
5.0%
0.0%
‐5.0%
‐10.0%
Source: Bloomberg
Our portfolio’s success in the next twelve months is predicated on a fundamental turn in several key
themes: energy, mining, Macau gaming, Swiss watches, Asian financials and Japanese industrial
exporters. The majority of these industries are at or near cyclical lows. Valuations are very attractive but
dividends are admittedly less secure. Much of our portfolio is feeling fundamental stress, but as they turn,
the stocks offer significant net profit margin and valuation multiple expansion. This is a very different
prospective total return equation compared to most developed equity markets, especially the US.
As discussed in our first quarter letter, the monthly volatility of our portfolio has increased recently as the
global markets continue to gyrate based on new macroeconomic data, changing monetary policy and
surprising geopolitical events. Rising US intermediate and long-term interest rates are pushing capital
out of the US; but there is less confidence in where the capital should go because of weak economies in
many emerging markets, political/monetary risk in Europe and limited transparency and confidence in
China. We expect our portfolio holdings to be relatively stable in the 2nd half of the year as we wait for
key investment themes to play out.
Thank you for your continued investment with Cheswold Lane.
Best regards,
Colleen Quinn Scharpf
Eric Scharpf
Matt Taylor
7 THE VIEW FROM CHESWOLD LANE…
Immuno Oncology: The Beginning of the End or merely the next act?
At Cheswold Lane, we are focused on finding companies and industries poised for positive changes in
returns on invested capital. In our third quarter letter last year, we wrote about the impact of the “patent
cliff”, the number of large blockbuster drugs going off patent, on the pharmaceutical industry. This
provided a unique environment where payers were willing to pay more for innovative drugs because their
overall pharmaceutical costs were declining due to significant blockbusters becoming generic. This
quarter, we are focusing on the rise of immuno oncology therapy and its huge potential impact on the
industry and two of our largest portfolio positions: Roche and Novartis.
What is immunotherapy?
Broadly, immunotherapy is the use of the body’s own immune system to attack cancerous tumors and
cells directly. This area is advancing rapidly and has had a number of exciting breakthroughs in the past
few years. It has the potential to make significant improvements in patient outcomes over traditional
cytotoxic chemotherapy drugs, radiation and surgery. These three traditional treatments have been the
backbone of modern cancer treatment since the second half of the 20th century. All three suffer from
serious side effects and only modest improvements in overall patient survival rate. While our
understanding of the biology of cancer has gotten much better since Nixon’s original “war on cancer” in
1971, the overall 5-year survival rate for all cancers has improved modestly, from 51% in 1975 to 68% in
2007. 1 This progress is frustratingly slow given the tremendous amount of resources that have gone into
researching the disease. From a health economics perspective, it is more troubling that the cost for
oncology treatments has been growing far in excess of the improvement in either patient outcomes or total
healthcare costs. However, very recent advances in technology and understanding of the disease are
raising the potential for a dramatic change. Some analysts are projecting that the improvement in
technology could result in a 33% decline in cancer death rates over the next decade.
1
http://report.nih.gov/nihfactsheets/viewfactsheet.aspx?csid=75 8 The overall size of the global oncology drug market now exceeds $100 billion, and is the single largest
revenue source in the global pharmaceutical industry. It’s one of the few drug treatment areas that has
continued to see increases in share of health care spending.
Global Oncology Market Forecast
Source: IMS Health
Immunology – how the immune system works
Over millennia, the human immune system has evolved to respond to an ever adapting stream of bacteria,
fungus, parasites, and tumors. The body has a number of active and passive defense systems in the blood,
working down to the molecular level to identify, target and destroy pathogens that are deemed hostile.
Sometimes the body’s own cells are identified as a threat. Through a complicated system of identification
by the T lymphocytes, a type of white blood cell, the immune system attacks cells that are “flagged” as
infected or tumorous. The flags then signal other T cells to attack and destroy the flagged cells. Different
types of T cells have different functions in the immune system. Some identify threats, some destroy
invading cells, others maintain a memory of past infections to speed the immune response if the threat
appears again, while suppressor cells “turn off” the immune system reaction at the end of an infection.
Cancer is the abnormal growth of cells forming tumors or spreading to other parts of the body. Unlike
other cells identified as threats which cause an immune system response, the body sees cancer cells no
differently than healthy body cells. Cancer is a slippery disease because there are many types of cellular
growth, in a wide range of body cells and functions. There are over 100 individually identified types of
cancer, each one sharing the common trait that the body does not identify the cells as a threat and allows
them to grow.
Too much immune response can cause serious medical problems if the body’s defenses attack normal,
healthy cells needed for the body to function. Rheumatoid arthritis is one of the most common of these
autoimmune diseases, as the body’s white blood cells attack cells around joints, causing painful
inflammation as well as inflammation of the heart, lungs, and kidneys. The science of understanding both
9 why the immune system can OVERREACT in the case of autoimmune diseases and NOT REACT in the
case of cancers is critical for medical advances to occur.
Because the body’s natural immune system already deals with abnormal cells every day, a lot of scientific
research has been focused on the key mechanisms that cause some cells to be identified and destroyed,
while cancer cells are protected from the immune response. The alluring hope is that the well-functioning
human immune system can be trained or modified to overcome a defect in the system, and attack cancer
without damaging necessary, healthy cells and organs. Almost 20 years ago, the first attempts at
harnessing the immune system focused on drugs that turned on the killer cells to attack. Interleukin-2 and
Interferon both promote the growth of T cells, which are a type of white blood cell that uses the molecules
on its surface to identify threatening versus safe cells. These cytokine treatments have been effective
against a relatively small set of cancers, as a more active immune system still misses many types of tumor
cells. Ultimately, if the T cell cannot identify a threat, having a lot more of them will not help.
More recently, research advances on two different sides of the immune system have dramatically changed
the approaches to cancer research. The chart below shows the two sides, “passive” which focuses on
monoclonal antibodies (mab) and “active”, which includes a number of different strategies to modulate
the immune system to identify and destroy cancer cells.
Source: Citigroup
The mab drugs emerged during the past decade, with Roche/Genentech, Amgen and Biogen as the
leading players with well-known biotech drugs like Herceptin, Avastin, and Rituxan. These drugs bind
antibodies to the surface of tumor cells and allow the body to attack cells that are marked with particular
antibodies. There have been significant improvements in patients’ outcomes relative to traditional chemo
and radiation. Mab drug researchers have expanded the types of cancers that they can be used to treat. At
the same time, improvements have been made in better identifying patients likely to benefit from this type
of treatment.
10 The other side of the chart covers “active” immune treatments. These represent the newest wave of
cancer-fighting therapies. PD-1 (Programmed Death Cell Protein) and PD-L1 (Programmed Death
Ligand) are two “checkpoint inhibitors” – which improve the body’s immune system to identify a tumor
cell. This technology discovery has been exceedingly well received by academics, the private sector and
the FDA. Merck and Bristol-Myers have been early leaders in checkpoint inhibitor treatments, with
Keytruda and Opdivo gaining initial FDA approval for melanoma treatment in the second half of 2014.
Drug companies see the potential for PD-1/PD-L1 treatments to go far beyond this initial approval.
Industry sales expectations for the whole PD-1/PD-L1 category exceed $25 billion by 2022. Besides
Merck and Bristol-Myers, who already have approved drugs, the other leading players in the field are
Roche, Novartis and AstraZeneca. All five leading players have trials using PD-1/PD-L1 treatments in
kidney, bladder, head/neck and lung cancers. An example of the significant growth potential is the
previously mentioned Merck blockbuster PD-1 drug, Keytruda – it is expected to reach $4+ billion in
sales in the next five years.
The industry expects a significant ramp up of new oncology drugs entering the market based on these new
treatment paths. These treatments will offer a new range of options for patients facing challenging
conditions or who have limited options for their disease. The chart below shows the industry’s estimate
of the number of new oncology drugs expected to be launched over the next six years. Most of these are
immuno oncology drugs based on either PD-1/PD-L1 mechanisms.
Expected New Oncology Drug Launches
Source: IMS Health
Besides PD-1/PD-L1 drug therapies, another promising immuno oncology treatment is CAR-T. This
treatment strategy, which uses a patient’s own T cells and adapts them to target specific tumor cells in the
body, could become as important to the oncology field as PD-1/PD-L1 treatments are. Novartis is the
undisputed leader in this emerging treatment area. There multiple cancer types that CAR-T is being
tested against today. The FDA has also been supportive of accelerated approval of these treatments.
11 Source: Novartis
For CAR-T, a patient’s blood is taken out of their body and the T cells are separated. Then, a virus is
used to insert DNA into the T cells that is specifically programmed to identifiy and destroy cancer cells.
Unlike conventional chemo cancer treatments, where a large number of healthy cells are destroyed, CART is focused on the cancer cells only. Dr. Carl June, who pioneered the first successful treatments with
modified T cells at the University of Pennsylvania called the T cells – self-replicating serial killers. They
are capable of locating and killing several pounds of tumor in a patient in just weeks. When Novartis saw
the initial results from the first three patients in Dr. June’s study, they quickly signed an exclusive license
for the technology in return for $20 million and a royalty. Currently, Novartis and Juno Pharmaceuticals
are the two leading players in this research field.
The Cost Equation
Progress will not come cheaply. Globally, governments pay for 60% of health care costs. Budget
pressures, exacerbated by demographics, are putting significant pressure on health care payers globally.
Pharma has gotten some breathing room the past few years due to the easing of the patent cliff. Going
forward, immuno oncology offers the potential to keep pharma out of the crosshairs of government
budget controls. Drugs that are used to treat chronic conditions, such as diabetes, HIV, and some blood
cancers are expensive and the duration of treatment lasts the lifespan of the patient. Payers are highly
motivated to attack these costs. For that reason, immuno oncology provides a better outcome for payers
and patients as “cures” negate the need for lifetime drug maintenance and services. Drug companies have
been aggressive with respect to price increases. In addition, many of these new treatments require longer
dosing/treatment times, which drive up the near-term costs as well.
12 Annual Growth in US Pharma Market Revenue Source: Credit Suisse As you can see above, the patent cliff took off 4-6% of US pharmaceutical sales in the past few years.
This gave the pharmaceutical industry room to press payers for strong price increases on the remaining
patent portfolio. Governments pay for value, and a long-term “cure” is worth significantly more than a
few months of additional survival. Innovative players will take share, while the “patent cliff” kills off
treatments that have not successfully invested in research & development. In general, treatments that
allow patients to return to a normal life, without on-going, chronic medical care saves payer costs from
hospitals, physicians, and other medical service providers. Manufacturers of those drugs will earn strong
returns from payers. All pharmaceutical companies are working aggressively on presenting their value
proposition to each of the major national healthcare systems. Their goal is to show the net present value
of improved outcomes to the overall health care system from their drug/treatment. The industry leading
companies start working with payers over a year in advance of their next oncology product launch in
order to validate the very high prices they are charging for the new drug therapies. They also want to
avoid the negative media with respect to the very high prices per treatment.
Oncology drug companies had a similar experience when the initial wave of cytotoxic (chemotherapy)
drugs was coming off patent. A number of companies launched “next generation” versions with very
limited differentiation in fundamental design and outcomes. Examples included drugs with reduced
dosing frequency or survival benefits that were measured in days relative to the standard treatments.
They received a lot of negative attention from payers, regulators, and patient advocates. As a result, the
major pharma companies now have very sophisticated “total life cycle” cost calculations that can show
the impact of new drug innovations on the total cost of the health care system.
13 Near Term Innovation Wave by Compnay
Source: FDA, CenterWatch
What does this mean for Cheswold Lane?
As I mentioned earlier, real drug innovation allows new treatment pricing to continue to grow, and even
potentially afford the industry to earn a greater share of overall healthcare spending. The drug industry is
already a high margin, high ROIC business; but accelerating revenue growth would add significantly to
the companies’ market valuations. We believe much of the past rally in the sector has been due to the
aggressive pricing of current on-patent drugs in the wake of the patent cliff. Immuno oncology provides a
second leg to the positive pricing story of the pharmaceutical industry. We believe our largest two
healthcare holdings, Novartis and Roche, have the depth of pipelines in leading areas of immuno
oncology to benefit from this $50+ billion revenue opportunity. Doubts about the ability of the industry
to innovate around a steep patent cliff have gone away in the face of substantial improvements in patient
and healthcare payer outcomes. We continue to research other innovators in this space and may be
adding additional names as more data about future pipelines emerge from other industry participants.
As always, please feel free to call or email me to discuss any aspects of this quarter’s investment letter.
Matt Taylor
Portfolio Manager
Cheswold Lane Asset Management
14