Business development companies with larger-scale portfolios are able to take part in higher-quality deals within the BDC industry and have more resilient income streams, which offers investors less of a negative impact to earnings versus smaller companies, says Sanjay Sakhrani, a Senior Vice President and Analyst at Keefe, Bruyette & Woods, Inc.
“I think from an investor standpoint, it’s a lot easier to invest in a more liquid name from a stock perspective than in an illiquid one,” Sakhrani said. “One of the problems for smaller BDCs is that they are small from a market-cap perspective, and it makes it tough to attract new investors into the name.”
Sakhrani has chosen Ares Capital (ARCC) as one of his top picks in the sector and he has an “outperform” rating on the company. He describes ARCC as one of the larger companies in the BDC space, which allows it to invest more broadly across the market. Sakhrani says ARCC’s dividend yield is about 10.5%.
“The reason we like Ares is they have a lot of liquidity and they’ve been waiting to deploy that liquidity when things got choppier,” he said. “And it seems to us that the competitive dynamic that existed before has eased somewhat, and you’re seeing a pickup in terms of yield, so I think they can probably deploy that liquidity in a more favorable investing environment today.”
The biotech sector is expected to continue to deliver innovation, top-line growth and manage to maintain a disciplined cost structure, allowing delivery of high single-digit or double-digit earnings growth, says Ravi Mehrotra, Ph.D, Head of Global Biotechnology Research at Credit Suisse.
“Given the macro environment, this is still a defensive sector to a certain extent. Therefore, in the current environment, I still think biotech will continue to garner significant interest,” Dr. Mehrotra said.
Dr. Mehrotra has an “outperform” rating on Biogen Idec (BIIB), which he says has been the strongest performer year to date in his coverage universe. He says Biogen’s BG-12, which has driven the company’s performance, may be a drug that changes the multiple-sclerosis therapeutic area, which is rare.
“While we see drugs which have changed the way people do business and have thus taken market share, we rarely see drugs which massively create a paradigm shift in their therapeutic area,” Dr. Mehrotra said.
Medical and technological advances play a larger role than the macroeconomic environment in investment opportunities for health companies specializing in drugs and devices in the heart and liver space, says Duane Nash, M.D., Senior Vice President in the equity research department of Wedbush Securities.
“Particularly at the developmental stage, it’s the internal catalyst which play a far bigger role than the macro trend. Occasionally we will see macro trends that occur to health companies. For example, right now, we aren’t seeing as many acquisitions by Big Pharma, so that tends to hurt these small companies,” Dr. Nash said.
Nash likes Endologix (ELGX), which has a best-in-class device for treating abdominal aortic aneurysms, a condition previously treated through major surgery, but now can be treated with ELGX’s medical device. Dr. Nash also says the company currently has a 11% market share.
“[Endologix’s] current device is best in class, and they have a new device, which should reach the European market next year and the U.S. in 2014 or 2015,” Dr. Nash said. “For the near term, there is lower risk but opportunities for strong incremental growth, whereas the longer term, there is the opportunity for fairly explosive growth.”
Less-discretionary maintenance companies in the consumer sector offer investors an opportunity to invest in more stable businesses during a slow-growth macroeconomic environment, with the potential of a pickup if the environment improves, says St. Denis J. Villere III, Investment Advisor and Partner at St. Denis J. Villere & Company, LLC.
“In this environment, as I mentioned, in the consumer sector we’re buying companies where people have to use the products, if that makes sense. They’re almost forced to buy them rather than being a true discretionary purchase,” Villere said. “It’s boring, and we like that.”
He says Pool Corp. (POOL) is the nation’s largest distributor of swimming pool construction products, as well as parts and maintenance, which are two-thirds of its sales. Villere says consumers are not expected to neglect their swimming pools during a sluggish environment, and the recurring revenue from parts and chemicals is attractive to him.
“We recently visited with management, CEO Manuel Perez de la Mesa, and he said that based on what’s going on with the chemicals and part-replacement business… he thinks that they can grow that business in the 15% to 20% over the next five years assuming no recovery at all in housing,” Villere said.
Defense companies are trading in single-digit p/e ratios and they are facing uncertainty with the domestic budget allocation, while defense spending is already expected to decrease by $450 billion in 10 years, says Peter Skibitski, Senior Analyst at SunTrust Robinson Humphrey, Inc.
“If you’re going to invest in the defense space, I would say just understand you probably have to have at least a medium-term time horizon,” Skibitski said. “However, from a valuation perspective, valuations do seem fairly reasonable, and a lot of these names do have fairly robust dividend yields in the range of 3% to 5%.”
Skibitski has a “neutral” rating on Lockheed Martin Corporation (LMT), and although he downgraded the stock from a “buy” recently, he still likes LMT’s exposure to the F-35 Joint Strike Fighter program, and he says the production is expected to help the company weather the leaner years.
“Because [the F-35 Joint Strike Fighter] program has not yet ramped into full rate production, I think that is going to provide them some sales support for some time, even in a declining DoD budget environment, because it’s so huge and it’s scheduled to be basically the largest program in DoD history,” Skibitski said.
Canadian banks are among the healthiest in the world and are currently trading at higher multiples than many peers, but their international expansion and dividend growth represent an opportunity for investors looking for stable, income-producing companies, says Willem Hanskamp, Chief Investment Officer at C.F.G. Heward Investment Management Ltd.
“[Canadian banks] are not the cheapest banks in the world. You wouldn’t expect them to be because they have done so well. So they get rewarded with slightly higher multiples than, for instance, some banks elsewhere that might have gone through some major restructurings or issues,” Hanskamp said.
Hanskamp likes The Toronto-Dominion Bank (TD) because of its successful expansion into the U.S. market and its earnings trends. He says TD Bank has resumed raising its dividend after regulators became more confident in the banking industry overall, and the bank seems financially secure.
“TD Bank has done actually quite well also in terms of earnings, earnings trends and the valuation is still very reasonable, around 11, 12 times earnings,” Hanskamp said. And he added, “since about a year ago, they can and they have started to raise dividends, and we think they will continue to do so.”
Pharmaceutical and biotechnology companies are moving toward orphan indications in a quest to bypass pricing pressure from patent cliffs and austerity measures in Europe, and obtain quicker approval by the FDA, says Ian Somaiya, Managing Director at Piper Jaffray & Co.
“Orphan drugs are focused on smaller patient populations. They are priced higher, so one might think there is going to be more price sensitivity, because some of them are priced at $250,000 to $400,000 a year. But their benefit is near absolute, as long as the patient receives the drug earlier in the disease cascade,” Somaiya said.
Somaiya is focused on Alexion Pharmaceuticals (ALXN), a larger-cap orphan drug maker. ALXN’s Soliris is approved for two different ultraorphan indications, and clinical data supports use in probably three or four new ones. Somaiya says the drug seems to offer benefit to a vast majority of the patients, which makes it unique among peers.
“[Alexion’s] stock had an amazing run over the past year, and probably has been one of the better-performing stocks since the middle of last year. But we’re also looking at a revenue stream that approaches $800 million this year that could generate peak sales of north of $5 billion. So we’re still early in terms of its eventual opportunities,” Somaiya said.
Defense sector stocks’ overall risk remains high and valuations low, says Michael F. Ciarmoli, Vice President with KeyBanc Capital Markets Inc., but defense companies have strong balance sheets and are generating strong free cash flows, even if there is a military budget reduction.
“Their backlogs are going to provide them with very good visibility in the coming periods. Even if the budget gets cut, there is still going to be a lot of money to extract revenues from. And if we do go into a double-dip recession, I think defense outperforms relative to industrials, so they could make for a good hiding place,” Ciarmoli said.
Ciarmoli has a “buy” rating on Orbital Sciences (ORB), a defense company with exposure to defense and commercial satellites, missile targets for high-end Ballistic Missile Defense Systems, an array of launch vehicles that cater to the commercial space market and the military space market, and NASA.
“[Orbital’s] exposure to Middle East war activities, optempo and any sort of force structure cuts within the Department of Defense is very limited,” Ciarmoli said. “They’re one of the few companies in the defense sector growing revenues and operating income at a double-digit organic rate while expanding operating margins.”
The potential of emerging markets for the larger pharmaceutical companies is underappreciated, says Damien Conover, CFA, Editor and Director at Morningstar, Inc. He says about 10 years ago, the emerging markets accounted for less than 5% of total sales, and over the next five years, they will represent more than 20%.
“You’ve got a tremendous amount of growth in emerging markets. I think that’s going to really help drive some sales through this patent cliff that big pharmaceutical firms are going into. It should also help fuel new product growth coming from the pipeline, augmenting growth coming into the 2014 to 2015 time period,” he said.
Conover says one of his top picks is Abbott Laboratories (ABT) because the diversified pharmaceutical company is a leader in the sector with its exposure to the emerging markets. Abbott also has strong divisions, including its nutritionals and vascular businesses, and has a relatively modest patent headwind.
“[Abbott] is a company that we think is undervalued. We like it because, while the rest of the industry is approaching the patent cliff, Abbott has a relatively modest patent headwind. We also really like one of its key products, HUMIRA, which is closer to 20% of its total sales and even more of the bottom line,” he said.
Stock selection will become key in the commercial aerospace sector, says Kenneth Herbert, Senior Vice President of Equity Research at Wedbush Securities. He is positive on the sector overall, but says those looking at the sector should be aware of concerns regarding availability of financing, labor issues and a macro slowdown in air travel.
“Both Boeing and Airbus have announced significant rate increases, up to 30% to 40%, on most of the aircraft over the next two to three years, and I fully expect those rate increases to continue to flow through, which is very good news for the supply chain and the original equipment manufacturers, OEMs,” Herbert said.
Herbert recommends Triumph Group (TGI), a small-cap name with leverage to the commercial cycle, both aftermarket and the original equipment build cycle. He also says TGI last year acquired Vought Aircraft, and they are still in the early stages of recognizing synergies and cost-savings opportunities.
“You are seeing nice earnings growth, going from this year of approximately $4.50 up to about $7 in peak earnings by fiscal 2015. A significant part of that certainly is coming from the volume increases and lean and productivity initiatives, but also benefits of the acquisition, which are flowing through at a rate of about $0.20 to $0.25 a year,” Herbert said.
