Something Old, Something New

by | Sep 30, 2023

As disciplined investors focused on quality and value, investment opportunities present themselves in a myriad of different ways. Two of our high-quality holdings in the Health Care sector, Novartis and Roche, were added to the portfolio under contrasting circumstances.

We inherited a position in Novartis when it first became a public company via our shareholding in Ciba Geigy prior to the merger between Ciba and Sandoz in 1996.  Our ownership in Ciba dated back to the inception of Sprucegrove in 1993.  Our ownership in Novartis now spans 30 years albeit in varying weightings over that period.  Interestingly, we were first introduced to Roche through Novartis, which had a strategic investment in the company.  We did our initial work on Roche in 2004 at which time it was added to the Sprucegrove working list.  Roche has historically been richly valued and it was not until early in 2023, fully 19 years later, that a post-pandemic decline in sales and increased biosimilars competition provided an opportunity to take an ownership stake at an attractive valuation.

Investing in companies that have a long history of above average profitability is one of the core pillars of our investment approach.  Novartis and Roche are no exception.  Over the last decade, Novartis has generated impressive average operating margins of 22% and an average ROE of 13%. We anticipate even better profitability for Novartis following its spin-off of its generics and biosimilars business, Sandoz, later this year. Roche has an even more compelling ten-year record with average operating margins of 27% and an average ROE of 43%.

For a company to be considered for inclusion in our portfolios, it must have a sustainable competitive advantage, a proverbial economic moat that will help ensure that it could continue to generate a superior record of profitability long into the future.  Both Novartis and Roche are regarded as being among the most innovative pharmaceutical companies in the industry.  Novartis is a leader in the fields of oncology, immunology, neurology and cardiovascular diseases. Roche’s leadership position spans both pharmaceuticals and diagnostics. In pharmaceuticals Roche has leading franchises in the areas of oncology, immunology, infectious diseases, ophthalmology and central nervous system diseases. The company is also the world leader in in vitro diagnostics, cancer diagnostics and diabetes management.

Another critical pillar of Sprucegrove’s investment philosophy is that companies maintain a strong financial position.  Financial strength is particularly noteworthy in the pharmaceutical industry where companies are required to make significant R&D expenditures, regularly face patent expiries, and need considerable up-front capital to launch new drug compounds.  A recent study by Deloitte estimated that in 2023, it now costs drug developers US$2.3bn to take a drug from discovery, through clinical trials and finally to market*. Both Novartis and Roche have long maintained strong financial positions.  Novartis currently has a net debt-to-equity ratio of 15%, which is an important measure of balance sheet strength. While Roche has higher net debt-to-equity of 60%, it is important to note that the company has historically maintained more modest debt and only increased its leverage to repurchase the shares that Novartis held in the company, a one-time event. Management intends to utilize the company’s free cashflow to quickly bring net debt-to-equity more in line with historical levels.

There is a constant balancing act in the pharmaceutical industry between patent cliffs and regulatory pricing pressures on the one hand and the need for new medicines to address genuine unmet medical needs on the other. This is why innovation is so critical with respect to long-term growth opportunities. Novartis has historically reinvested ~18% of annual sales back into R&D and has 6,000 research professionals advancing a pipeline that includes 150 projects in clinical development.  Roche is dedicated to innovation, reinvesting between 18-22% of sales in R&D over the last decade.  Roche is unique among the big pharma players in that most of its pipeline is internally developed, rather than in-licensed. With 98 clinical trials in progress, Roche is considered to have the second largest pipeline in the pharmaceutical industry.

Since becoming shareholders of Novartis following the merger in 1996, we have met regularly (as we do with all our portfolio companies) with management in our office, at conferences and at their headquarters in Switzerland.  Novartis’ current management team remains committed to innovation and improving the efficiency of its R&D by discontinuing unpromising compounds and ensuring that its lead drug candidates are best in class rather than ‘me-too’ drugs.  While Roche is new to the portfolio in 2023, we have nevertheless met frequently with management over the years that the company has been on our working list.  Like Novartis, Roche management remain devoted to being an exemplary research organization.  Roche’s new CEO, Thomas Schinecker, has committed to accelerating the speed at which compounds move from the early to late stages of the pipeline and is more open to in-licensing or acquiring novel compounds from other biotechnology innovators to compliment internal efforts.

Novartis has gone through a number of changes over the years that we’ve owned a stake in the business.  Today it is a company that is now singularly focused on innovative medicines. Not unsurprisingly, Novartis’ valuation has gone through highs and lows over the past 27 years. We have used that volatility to opportunistically add to and trim our position over the years.  Today, we consider Novartis fairly valued, and it remains a major holding in the portfolio. The position in Roche was initiated earlier this year and we will continue to build our stake in the name as long as it is attractively valued. In Novartis and Roche, we have an ownership stake in two different yet high-quality pharmaceutical companies. Our hope would be to retain ownership of both over the next 30 years provided they maintain their caliber.

[1] Source: Sprucegrove, MSCI, FactSet
*Seize the digital momentum – measuring the return from pharmaceutical innovation 2022, Deloitte Centre for Health Solutions, 23 January 2023.

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