SA Interview: Healthcare Investing With Fundamental Diagnosis

Feature interview

Fundamental Diagnosis is an individual investor and former sell-side analyst in healthcare at several top investment banks. We discussed how to use DCFs as a valuation framework, why the downstream effects on inflation are more important than COVID as a catalyst for the market and how to better evaluate statements made by experts or other investors.

Seeking Alpha: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ?

Fundamental Diagnosis: I suppose one could call me a value investor. I am looking for companies where the discounted value of future cash flow forecasts materially exceeds the current value of the company in the market. I spend a lot of time on forecasting fundamentals. I try to keep some degree of perspective on the macro picture as well. While I personally invest across the entire market, my expertise is in healthcare, which is what I write about.

SA: To follow up, given how broad the healthcare sector is, do you focus on certain industries? If so, which ones and why? Are there more mispricings in certain industries or market cap sizes?

Fundamental Diagnosis: The only part of healthcare where I feel out of place is in small biotech, where stock prices moves are often more about clinical data, and real cash flows can be years away. I think it is possible to get mispricings across all cap sizes and industries. COVID attracted a lot of attention to the sector, and created some interesting opportunities, where new investors came into the sector without a good grasp on some of its idiosyncrasies.

SA: Can you discuss how an in-depth competitive analysis can reduce risk and/or serve as a source of idea gen? Can you give an example?

Fundamental Diagnosis: Really understanding all the competitors in a sector takes a ton of time, so many analysts cut that corner. But if you really dig into it, sometimes you can get an edge by realizing that competition has less teeth than it first may seem, or that competition is more robust than you first realized. An example of the former category is next gen sequencing, where I think the incumbent Illumina (ILMN) is much safer from new competitive threats than the hype around these smaller companies would suggest. An example in the latter category is generic drugs in the U.S., where competition over the past five years has gotten much more problematic for the big incumbents like Teva (TEVA) and Viatris (VTRS).

SA: How should investors use a company’s investor presentation in the research process? In general what mistakes do you see investors make here?

Fundamental Diagnosis: You have to realize that companies are not unbiased. They will present information that flatters them, and they don’t have an obligation to present all angles. Nonetheless, sometimes these documents contain information that isn’t in filings. My general recommendation is to compare what all the companies in the same industry put in their filings. If company A says the market is growing 5%, company B says 8%, and company C says 10%, try to understand why those differences exist. Are they serving different parts of the market? Are they referencing different sources? Does management legitimately have a differentiated view of the market?

SA: Can you discuss your valuation framework for investing in the healthcare sector? What are best practices for using DCF models?

Fundamental Diagnosis: I try to think of stocks the same way I think about bonds. What is the yield of the stock based on the cash flows that equity investors are entitled to. (The extra step in stocks is to evaluate whether management will deploy that capital prudently). DCFs are useful for determining the yield for a given forecast. DCFs are too sensitive to multiple variables to be overly precise about price targets. But it is possible to say “given this set of forecasts, the current stock price suggests a yield of about x%,” where x is the discount rate. Then you can compare that to treasuries, corporate bonds, or other stocks to make useful asset allocation decisions.

SA: Can you discuss how focusing on the overall narrative for a stock and/or industry can be beneficial or harmful? Can you give an example?

Fundamental Diagnosis: It’s really been striking how narrative can completely overtake fundamentals sometimes. Perhaps this is because as social animals, humans are just wired to grab on to a good story. In healthcare, you saw this with a stock like Moderna (MRNA), where the reality of cash flow forecasts just didn’t live up to the extreme hype at the height of COVID. In the broader market, you saw this with hypergrowth tech, where a narrative clearly won the day over actual cash flows until reality started setting in about a year ago. This kind of thing plays out all over the market. Electric vehicles won’t displace ICE fast enough to justify recent valuations. Fintech won’t be nearly as disruptive to legacy finance as valuations suggests. Oil and gas are not going away in a decade, as 2020 valuations suggested. It’s easy to invest in a narrative. It’s much harder to make real forecasts, but that’s how money is made.

SA: Since the start of the COVID crisis, investors have heard a lot of different opinions on the topic – how can they better evaluate statements being made so they can make a more informed decision (or even gain an edge when investing)? Can you give an example?

Fundamental Diagnosis: It was somewhat easier at the beginning of the crisis to spot obvious errors, such as the assumption in the mainstream media at the time that a vaccine would be a decade away. Everything is more complicated now, and I would argue that COVID isn’t a major catalyst for the market or even individual stocks at this point. The downstream effects on inflation are much more important now. My general advice is this: First, find trustworthy sources of information. In healthcare, I like Stat News, as one example, but I also look for obscure blogs written by wonkish experts. Second, try to compare the decision you make from the “outside view” with the decision from the “inside view.” These are terms superforecasters use to distinguish looking at the forest versus looking at the trees. I have been trying to figure out how opioid settlements are going to shake out for generics manufacturers. The outside view tells me that settlements will happen and that they will be manageable. The inside view tells me that things are a lot more complicated than they first appear, and maybe I shouldn’t be so confident in the outside view. I’m still not sure which will prevail, but I feel like this type of perspective gives me a solid handle on the situation.

SA: What’s one of your highest conviction ideas right now?

Fundamental Diagnosis: I’ve written about Organon (OGN) on Seeking Alpha as a high conviction idea. This hasn’t changed. The stock hasn’t moved much, despite fundamentals improving. This is a spin-off from Merck that is trading very cheaply. People are comping it to generics companies, but it has none of the legacy and legal issues that those companies face. I like this management team. I think they will be able to prudently build out a portfolio of women’s health products, and they are already executing on that strategy. I still think it’s a double over a multiple year horizon.