Client Investment Letter April 2024

“You ask what is our aim? I can answer in one word: Victory. Victory at all costs, victory in spite of all terror; victory, however long and hard the road may be. For without victory there is no survival.”  – Winston Churchill


Fed Chair Jay Powell is no Winston Churchill. For all intents and purposes, he has already declared victory over inflation with all systems go for the first rate cut in June, despite not yet fully taming the price pressures he has been waging war on for two years.


No doubt, the Fed’s fight against inflation has thus far been effective, with headline CPI steadily dropping from over 9% in June 2022 to just above 3% in recent months. Yet, it remains stubbornly above the Fed’s 2% target, and ticked higher in January and February. In the press conference following the Fed’s March meeting, Chair Powell acknowledged that the road to 2% inflation would be “bumpy” and he emphasized several times an expectation that getting there would take “some time,” new language that many took as a subtle abandonment of his inflation target.


To be sure, there are structural forces at play that will make that last little bit of inflationary pressure the most difficult to stop, such as runaway federal spending, a tight labor market, the energy transition, and the need to fortify global supply chains in a fragmenting geopolitical environment. But that seems to be a worry for another day by perhaps another Fed chair. It is an election year, after all, and though the Fed is apolitical in theory, charting a policy path outside of all expectations – like staying firm at a decades-high Fed funds rate, or even raising rates again and risking a recession – would likely elicit outrage from both parties. So, the Fed is doing what it often does, erring on the side of too much accommodation.


Overall U.S. financial conditions have already been getting less restrictive, and this has shown up in the feverish risk-taking impulse across assets. Cryptocurrencies, including not just bitcoin but completely speculative memecoins, are headed to the moon, as they say in that world. Options contracts due to expire within a day are seeing enormous volume. Money-losing IPOs are often rising 50% on their first day of trading. And, of course, anything even tangentially related to artificial intelligence or obesity drugs is like manna from heaven. The fear of missing out (“FOMO”) has clearly taken hold of investor psyche.


Normally, the Fed is cutting rates to contain the fallout of a potential crisis: think the Russian debt default and Long Term Capital Management failure of the late 1990s, the bursting of the dot-com bubble in 2001, the Great Financial Crisis, and Covid. Yet, despite overwhelming exuberance and an economy that’s held up much better than many feared, the Fed seems prepared to cut rates as many as three times this year while also slowing the pace of its balance sheet reduction, creating a risk of reigniting inflation that leads to a stop-start monetary policy. In the 1970s, central bankers prematurely claimed victory over inflation, only to see its resurgence; it took a severe recession to ultimately defeat it for good.


Should inflation return, the great companies we invest in on your behalf will adapt better than their competitors. The reasonable valuations that we require upon purchase will provide a margin of safety. Our extended time horizon provides an advantage over fast-money investors trying to hit monthly performance targets or individuals, struck by FOMO, hoping to get rich quick. The cash cushion we have in your account provides optionality for new ideas during periods of market stress while earning an adequate 5% risk-free. Above all else, our investment process remains disciplined; we’ve been around long enough to not chase shiny objects but rather to try to uncover lesser-known gems.


During the first quarter we started a new position in one such company, Roivant.


Roivant is a biotech holding company with a number of focused subsidiaries, called “vants,” built across various therapeutic areas to maximize ROI. The strategy is to find orphaned drug candidates that have been shelved by big pharma, create a new vant for each where the economics are usually shared with their partner, develop them with the resources and support of Roivant, and then, once de-risked, sell it. And because Roivant is incorporated in Bermuda and subject to UK tax law, they pay no capital gains tax when they sell.


Led by a former Goldman Sachs banker, this has been a very successful model to date. Most recently, in December the company sold its Televant subsidiary to Roche for over $7.1 billion in cash. Following that sale, the cash on Roivant’s balance sheet, plus the market value of its stakes in two publicly traded subsidiaries, yields a negative enterprise value, which means we are gaining access to many sources of potential upside for less than free. This is a mispricing that we do not believe can persist.


Immunovant is the most valuable of the remaining vants, with a market cap today of approximately $4.7 billion, making Roivant’s stake worth about $2.4 billion. Its focus is on autoimmune disease via an anti-FcRn platform which has the potential to be applied to many indications. This is a multi-billion-dollar commercial opportunity, and with its lead drug de-risked and the biotech M&A environment heating up, Immunovant is widely expected to be sold this year.


Another interesting source of potential upside is a patent infringement lawsuit that two subsidiaries, Genevant and Arbutus, have against Moderna and Pfizer. In an understandable hurry to produce a Covid vaccine in record time under Operation Warp Speed, intellectual property of other companies was allegedly infringed upon. The likely settlement, in our opinion, will be some low- to mid-single-digit royalty on Moderna’s $40 billion in legacy Covid vaccine sales. The Pfizer litigation is following a separate track, about 8 months behind, but an even bigger potential settlement lies ahead on its $80 billion in cumulative Covid vaccine sales.


As we navigate a new monetary policy regime that is more inflation tolerant, and as political-campaign rhetoric amps up into the election, the market environment may become more volatile. But we will remain vigilant in our goals to protect and grow your money, in that order. Because our clients’ financial wellbeing is the only victory we need.


Penn Davis McFarland, Inc.
April 2024