Ted Seides: Hello. I’m Ted Seides, and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at capitalallocators.com.

Voiceover: All opinions expressed by Ted and podcast guests are solely their own opinions, and do not reflect the opinion of Capital Allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Capital Allocators or podcast guests may maintain positions and securities discussed on this podcast.

Seides: On today’s show, we’ll discuss another empty room, an opportunity ignored by most investors because they either don’t want to or can’t participate. My guest is Andy Acker, a portfolio manager at our anchor sponsor, Janus Henderson Investors, where he manages the firm’s health care strategies. Janus Henderson is a global asset manager with $300 billion in assets under management, and Andy oversees the firm’s Global Life Sciences strategy and its Biotechnology strategy. Biotech stocks have been crushed despite significant advances in drug development, making it a proverbial empty room with only specialists and contrarians left standing.

Our conversation starts with Andy’s path to becoming a health care investor, scientific innovation over his time at Janus Henderson, translation of science into commercial success for businesses, and the 90/90 rule for house stocks behave. We then turn to his investment process across filtering ideas, research, assessment of management teams and commercial success, portfolio construction, trading around names, and private crossover investing. We close with Andy’s perspective on opportunities and risks to the space from here, and the green shoots he sees that might fill seats in the empty room.

Please enjoy my conversation with Andy Acker. Andy, great to see you.

Andy Acker: Great to see you, Ted.

Seides: Why don’t we start with your background and your path to becoming an investor in this space.

Acker: Sure. Well, I actually come from a long line of physicians. So my mother, my father, my grandmother and grandfather are all physicians. So you could say that medicine runs in my blood. I got as far as applying to medical school before I realized that my true interests were really more on the investing side. I also felt that I could have a bigger impact as an investor than I could as a practicing physician. And then, what’s been really gratifying is that’s turned out to be true. The other less well-known factor is that I really don’t like the sight of blood, which makes me sometimes pass out. So I think I chose the right career path.

Seides: And how did you get started once you knew you wanted to be an investor?

Acker: Yeah, sure. So I studied biochemistry as an undergrad at Harvard, and I actually studied biochemistry and economics. And after I withdrew my applications from medical school, I actually went to Morgan Stanley for the first three years of my career, this was back in ’94 to ’97. And so worked initially in capital markets, and then in venture capital. I really got a chance to invest professionally for the first time, which was really exciting for me to do all the analysis and try to pick the stocks that are undervalued. After that, I went to business school with you, and in business school what I found is I was coming home from class every day, and I couldn’t wait to get on my computer and just start researching stocks.

And I was spending more and more of my time doing that, investing in my personal portfolio. And then, when I was interviewing, I probably interviewed at a hundred different firms coming out of school, really trying to exactly focus in on what I wanted to do. And really when I interviewed at what was Janus then, now Janus Henderson, I just fell in love with the place. They were investing the same way that I was. It was really a focus on long term investments, and identifying companies that were undervalued, and that was really exciting to me. I actually recommended a few stocks during my interviews that a few of them, they ended up buying and they turned out pretty well. So they made me an offer and I joined the firm here in ’99, and have been here now 23 years.

Seides: So almost a quarter century in this space. And would love to hear your perspective on maybe where we are today in terms of the opportunity, both about the underlying business and the market for these stocks. But why don’t we start with the science and the business.

Acker: Yeah. So I started as a biotech analyst, biotech and pharma, and then in 2003 I became the assistant manager on our healthcare fund, 2007 became the lead manager. And when I think about what we were investing in back in the late ’90s, early 2000s, you think about the Human Genome Project. That was the global collaboration to sequence the first human genome. That was completed back in 2000, and it created a lot of excitement. We can now sequence the human genome for the first time. The problem was that took 13 years to complete and cost $3 billion just for one genome. So when you think about that, although it generated a lot of excitement. And when I first started biotech stocks we’re very in vogue and people were excited about them. But when you think about the practical applications, there really weren’t that many back then. Just took too long. It was too expensive for it to be really helpful. Since then, we have made dramatic progress to the point where now we can sequence a human genome literally in hours and we can do it for hundreds of dollars. And what that means is scientists now have a much better understanding of the genetic causes of disease. And they can develop new therapies that directly target those underlying genetic defects, and so that has been a major advance. That’s just really one example of the improvements in productivity that we’ve seen in the industry. If you think about just a few years ago when the COVID-19 pandemic hit, historically it took 10 years to develop a new vaccine and the fastest ever was four years. Had that been the case, we would’ve had millions of more people die, because instead of 10 years we were able to develop two highly effective vaccines in only 10 months.

And that we think again, saved millions of lives around the world. But that’s again, just one example of all new modalities of treating human disease that are emerging today. And if you think about the development of, for example, cancer treatments. We’ve been treating cancer for more than 120 years, initially using radiation therapy and surgery, for about 70 years we’ve been using chemotherapy. But if you think about the way chemotherapy works, it’s basically a chemical that destroys all dividing cells. And so that’s good to try to kill cancer cells because they’re rapidly dividing. But unfortunately some of our healthy cells are also dividing. And so when you give chemotherapy systemically, it causes a lot of toxicity. What’s happening now is we’re getting much more targeted therapies. So we can, for example, target specific genetic defects, this is called precision oncology. We’re all familiar now with mRNA with the vaccines.

So we can actually put in mRNA that will make a protein, but then we can also knock down RNA in a way that will stop a harmful protein from harming a patient, or potentially that could be curative for a disease. We even have cell therapies now where we can take cells out of the body, reprogram them to identify and attack and kill cancer cells, and reinfuse them into the body. Essentially, what started is just oral small molecule pills to where you could actually replace a missing protein in a patient to antibodies that are highly specific for a target, and we can use those for cancer and other diseases. And then, we’ve moved even beyond that to antibody drug conjugate. So if we think about that chemotherapy before, instead of giving the chemotherapy systemically where it goes all around your body. You can actually create like a precision guided missile where you can attach a chemotherapy molecule to an antibody, and then again directly target cancer cells using that.

So there’s just all new modalities of treating human disease that didn’t exist when I started 23 years ago. And just the innovation, especially in the biotechnology area, has been accelerating dramatically. Another way to think about this, in the last five years there have been 256 new medicines approved in the United States. That’s up over 100% from where we were just 10 years ago. So many of the things we’re seeing today would’ve seemed like science fiction just 10 years ago. We’re just seeing this across every field, especially these gene therapies. Actually, just recently in Europe we had the first gene therapy approved for the treatment of hemophilia. We are now getting close to filing the first gene therapy for the treatment of muscular dystrophy, which is, again, these are huge unmet medical needs.

When you think about muscular dystrophy, this affects tens of thousands of boys who essentially have a defective version of the dystrophin protein, which is the shock absorber for your muscles. And if you have a defective form, these patients gradually have deterioration of their muscles to the point where they end up in wheelchairs by their teens, and they generally die in their 20s. And there’s been no disease modifying therapy. And now we have a gene therapy that could be launching potentially by the middle of 2023. So we’re just seeing so many exciting developments. It’s made it a lot of fun to be an investor in this space.

Seides: How do all of these scientific advances translate into commercial success for the businesses?

Acker: Yeah, that’s definitely a big part of what we do. Our framework for how we invest in the space is something we call the 90/90 rule. And what this refers to is the clinical and commercial risks of developing a new therapy. And so if you think about a product that begins human clinical testing, if you look at the industry over the last multiple decades, 90% of the products that begin human clinical testing never make it all the way to market. And so this is a very challenging industry, costs about a billion dollars to develop a new therapy. And the main reason for that is because 90% of them will fail. So if you think about it as an investor, especially as a long investor, then you’re really trying to find the needle in the haystack, the one out of 10 drugs that can make it all the way to approval.

And these drugs go through the different clinical stages of testing. So phase one, you’re generally testing it in healthy volunteers, in a small number of patients, trying to establish initial safety. In phase two, that would be a somewhat larger study, maybe hundreds of patients where you’re actually trying to figure out the dose response and what would be the optimal dose. And then in phase three, which is the final stage of testing called the pivotal trial, you’re generally testing it in larger number of patients, maybe hundreds or even thousands of patients trying to prove safety and efficacy. And if you think about the industry statistics for a phase three study, the average success rate of the industry is about 50%. So if you think about that, that means you’re spending hundreds of millions of dollars to run this trial, and the outcome you could

say is a coin toss. And that is the way that the market views. The way that we see is that the market views every drug as average. They just say, “I don’t know if this drug’s going to work or not. It’s a coin toss. So I’m going to apply 50% probability of success, and that’s how I’m going to value this company before that key event.” And we call these events binary events, because there’s really only two outcomes. A drug either works and it proves to be safe and effective or it doesn’t. And when you have a success, you can have a stock that could be up 50, 100%, or more in one day. And then, on the other hand you can have one that fails and you could have a stock that could be down 50, 70, 80, 90% in a day. So it goes both ways. So if you think about a pivotal study, our view is that not every drug is average.

And in fact, you can do deep fundamental research and really focused on trying to understand the science and the business, to figure out which ones are more likely to work. So we think we can identify some that might be 70, 80% likely to work, and similarly identify ones that are 70, 80, or more likely to fail. And if you can do that, you don’t have to be perfect. But if you can do that better than the market, then you can generate consistent outperformance over many, many years. And so if you think about it, how do we try to identify the ones that are likely going to work? When you think about it, that trial, in order for it to work, you have to get the right drug to the right place at the right time, in sufficient quantities and in the correct patients and in a properly powered clinical trial. If all of those are lined up, then you actually have a very good chance of success.

We would say 70, maybe 80% odds of success if everything is lined up the right way. On the other hand, if anything is off, so you could have the right molecule, but maybe you’re testing the wrong patients, or maybe your clinical trial wasn’t adequately powered, or maybe you’re not getting sufficient quantities to the right place, so you can’t dose it high enough because of side effects. So if any of those are off, then you have a trial that’s highly likely to fail. So with our Global Life Sciences strategy, we’re primarily looking for long ideas. So we’re trying to own the ones that we think are going to work, and there we just try to avoid the ones that we think are going to fail. We also can go both long and short, and invest in public and private opportunities. And there we can actually try to short those stocks that we think are unlikely to work.

Seides: So what’s the other side of the 90/90 rule? If the first side is that 90% of the clinical trials will fail.

Acker: For the one out of 10 drugs that actually makes it all the way to market, then you have the commercial risk of a new product launch. And what we’ve found, again, in more than 23 years of investing in healthcare is that the consensus estimates from Wall Street are wrong about 90% of the time. And those estimates can be either way too high, in which case that’s a stock that you want to avoid or potentially short, or they can be way too low. So you might say, “Well, you have all these smart analysts on Wall Street analyzing these companies. How can they be wrong 90% of the time?” And I think it’s a couple factors really. One, it’s actually very difficult to estimate what these new product launches are going to do. If you think about it, many times you’re launching a product into a disease where there’s never been a treatment before.

And so it’s not well known. For example, how many patients really have this disease? How many of those patients have a severe enough disease that they would actually try to get a new treatment? What’s the pricing going to be? Is it going to be reimbursed? Are the physicians going to use it? Are the patients going to take it? Are the patients going to continue to take it? All of those can have an impact. And so the way that we assess it is something that we call the three Ps, and that refers to the physicians, the patients, and the payers. So we need to understand the incentives of each of those three groups in order to figure out, is this going to be a good launch or a bad launch? And what we found is, again, all three of those groups need to be aligned and have the proper incentives to use a new therapy for a launch to go well. And if any one of them is off, then you typically have a launch that would disappoint. So let me give you a few examples. So if you think about, first of all, the physicians. So the physicians write the prescriptions that affect 80% of healthcare spending. And so we need to understand, are they aligned? Did they feel that this new therapy is an improvement over the standard of care? Physicians practice medicine and they tend to practice the way they have been practicing for the last 20 years, unless you give them a real reason to change. So they need to feel that this therapy can really improve care for their patients. It needs to be fairly convenient for them. Sometimes there are financial incentives that you really have to understand. For example, some therapies, a physician can actually get an additional income by administering a medicine. In other cases, a medicine could replace something that they’ve been doing for 20 years that was a major source of their income.

So all of those factors can influence whether they’re going to adopt a new medicine. Then of course you have the patients who actually have to take the medicine. And so we need to understand, will the patient get a real benefit? Are they going to feel better, function better, survive longer? Those are all elements that will encourage a patient not only to try a new medicine, but to continue to take it, which is what you really need for a therapy to do well. And then of course, one of the factors there is, how convenient is it for them? Is it a once-a-day pill? Or is it you have to come in and get an infusion every week? Does it make them feel better? Or does it make them feel worse? Some medications have significant side effects. And so if you’re making a patient feel terrible for a disease that they don’t feel bad when they have the disease, they’re not going to stay on it. But then importantly, can they afford it? How big are the copays? And that’s become a bigger and bigger issue, especially in the United States that copays have become unaffordable for some of these medicines, and so that’s where the payers come in. And so you have to understand, do the payers view this as an improvement in the standard of care? Is it worthy of reimbursement? And if it is, then they’ll make the copays manageable so that the patients can continue to take it. If not, or if they think the therapy is too expensive, they can create significant roadblocks. And essentially, any of those can kill a new product launch and cause it to disappoint.

Seides: So much of the analysis of both the drug, and then the commercialization of the drug seems very idiosyncratic for each individual drug. And yet at the same time, you’ve had these big moves at times in the markets for the sector as a whole, and particularly last couple years have been just terrible for the sector. So we’d love to hear some of your thoughts on taking that analysis, and then how you find the nature of opportunities when you’re applying it into the markets? Other than that binary call when the FDA is about to announce an approval.

Acker: Right. So if we think about, I would say health care and especially biotech. Biotech is one of the most volatile sectors out there. So back when the S&P Select Biotech Index and the XBI, which is an ETF that tracks that broad Biotech Index. That was created back in 2006, so about 16 years ago. Since that time before the recent bear market, and we’ll get to that, but there were 11 effectively bear markets in that 16-year period where these stocks declined at least 20%. And obviously, we don’t think the value of these companies are changing as dramatically as the stocks. But it is a sector that’s highly prone to psychology, market psychology and whether investors are optimistic or pessimistic. So it’s a very volatile sector, but the value of the companies don’t change nearly as fast as the stocks often do. And that’s actually what creates the opportunity, I think, because these stocks are so volatile.

But if you have a team that can really dig in and understand the science and the business, and identify the products that have underappreciated clinical and commercial potential. Then the pullbacks in the market actually give you the opportunity to buy into those companies at much lower valuations. And so let’s address the recent one. So first we had the pandemic hit, and we talked about the amazing progress that this industry created in addressing the pandemic. COVID-19 didn’t even exist three years ago, but in 2021, the industry sold $75 billion of products addressing COVID-19, either vaccines or treatments. So that’s pretty remarkable. We went from zero to 75 billion, and then probably heading much lower because the pandemic isn’t as much of a problem as it was a few years ago. But when we made that progress, that created a lot of excitement about the biotech sector.

And so you had a lot of investors coming into the sector who maybe didn’t really fully appreciate the volatility and the risks of investing in the sector. And so first we got a big run up. We got a lot of companies going public at valuations that were higher than they had been historically. And then, because it’s an industry where 90% of drugs fail, you started getting a lot of things that didn’t work out as people had hoped. And so there was a lot of disappointment, and then you had a big rundown. And in fact, between February of 2021 and June of 2022, we had one of the worst bear markets in biotech sector in history. So on an absolute basis these stocks decline 64%, and relative to the healthcare sector, they traded down about 75%. So we’ve never seen anything like that. On average, these stocks decline about 30% and it happens in about three months.

In this case, it was 65% and it happened over a year and a half. And if you think about the development stage biotech industry, it lost 70% of its value over that 18-month period. Now, after that, you get to a point where actually 200 different companies were trading below the levels of cash on their balance sheet.

That’s highly unusual. We’ve never seen that before. Even going back to the global financial crisis and the bear market, the dot-com crash. We never saw that many companies trading below cash. And not only were they trading below cash, in some cases they were trading 50 to 80% below cash. So essentially the market was saying, “These companies are worth more dead than alive, and the value of their R&D is negative.” Now that we thought was too extreme, and it wasn’t just those companies, it was many companies where we thought that they were trading as if their R&D was worthless, their pipeline was worth zero or negative.

And especially, where we started to see a lot of value in the market was an early commercial companies. So these are companies that already have a product on the market. They have meaningful revenues, in some cases, hundreds of millions, even approaching a billion dollars in revenue but not yet profitable. And so we know that with rising interest rates, that unprofitable companies were highly out of favor. And so the market was not really differentiating between, let’s say early development companies that could be many years away from even having revenues, versus early commercial companies that we view as only being maybe a year or two away from profitability. And so if you think about the development of a biotech company, they start in early development, maybe preclinical or early clinical development, then it takes multiple years to get to late-stage development where one pivotal trial could get approval for your drug.

So we were seeing a lot of value, especially in these early commercial companies because they reviewed as unprofitable. But again, the market was giving no credit for the pipelines. And we’ve seen even just recently where the opportunities are starting to get more attractive, we’re starting to see M&A activity pick up as well.

Seides: I’d love to turn to some aspects of your investment process. We’ve touched on some of them. How do you go about doing your research into the science and the business? But let’s start with the science.

Acker: So I’m fortunate to lead a team of analysts that I think is really just incredible. In total now we have nine senior investment professionals at the firm with more than 125 years of experience. And when you think about the therapeutic side, I studied biochemistry as an undergrad at Harvard, and I’m the least educated member of our therapeutics team. So we have three PhDs and an MD on the team, and really the goal is to really dig in and understand the science. So we spend a lot of time, for example, reading clinical literature, attending medical conferences around the world, in the age of Zoom that’s gotten a little bit easier. We used to travel all around the world. But we’re meeting with key opinion leaders in every therapeutic area from cancer to heart disease to diabetes. And we want to understand, first of all, what is the current standard of care? How do the doctors practice medicine in each of these fields? What are their go-to therapies? And then, what are the unmet medical needs? What are the areas where a new therapy could be beneficial? Whether it’s a disease where there’s nothing available, or one where there are treatments available but you could do much better for these patients. And so we spent a lot of time talking to these key opinion leaders. We’ve developed relationships with some of them over decades. And we’re always canvasing, essentially all of the therapeutic areas to figure out what are the new products coming that we think can change the practice of medicine. And we focus on these companies that are addressing high unmet medical needs with novel products. Because it’s our view that regardless of the economic situation, the reimbursement situation around the world, if you truly address an unmet medical need, there is always demand for that and there’s always reimbursement for that.

So we start with that, what is the unmet medical need? And who are the companies that are developing therapies that can address those unmet needs? That’s part of it on the therapeutic side. And then, on the other side it’s really, what are the companies that can make the healthcare system more efficient?

Because as we get older, we all spend more on medicine. The elderly spend three times as much on healthcare and four times as much on medicine as the rest of the population. And so the aging demographics is going to drive higher healthcare spending, but there’s always a demand for how can we do things more efficiently? How can we save money in the system? What are the new treatments, or new devices, or new diagnostics that can actually improve the quality and length of human life, but do so in a cost-effective way?

So that’s what we’re always focused on. And then, when we find those companies, when we find a product that we’re excited about, we really dig in and try to understand the company. We try to understand, first of all, what stage is this product in? Is it getting close to market? Is it very early? What’s the quality of the management team? And so we spend a lot of time interviewing the management team. We analyze the financials. We build our own detailed financial models. And ultimately what we try to do is we’re projecting out the future. So what are the earnings? What are the key revenue drivers for the company? And then, how is that going to translate to earnings and ultimately free cash flow? And then, we use a discounted cash flow approach to estimate the intrinsic value of that company.

And so then, what we look to do is invest in the companies that trade at a substantial discount to that estimate of intrinsic value. So generally we’re going to be looking for companies that trade at least a 25% discount to what we think is the intrinsic value. And the earlier and riskier the company is, the more discount we’re going to need to invest in that company.

Seides: So in a lot of industries, the quality of a management team ends up mattering tremendously in the relative success of the business. I’m really curious in such a science driven model of success. How important is management team both to the success of a particular drug let’s say, and then your assessment of the business of the drug compared to the quality of the management team?

Acker: Yeah. It’s a great question. Probably the biggest mistake that I’ve made in my career is under appreciating how important a good management team is. Because if you have a great molecule and it meets a bad management team, you can destroy a tremendous amount of value just by making bad decisions. You don’t dose that drug adequately, you put it in the wrong patients, you don’t do the appropriate studies, or you just take way too long and other companies pass you by. So a bad management team can destroy a lot of value. On the other hand, a great management team can add a lot of value, because they may figure out early that this molecule isn’t good enough, and then they can actually go out and do something about it. They can develop a new therapy that’s much better than the one that they had been developing before, or they could go out and acquire one, they can do business development.

So a great management team can actually add a tremendous value, right? I’ll just give you one example that just comes to mind, because it was fairly recent. Global Blood Therapeutics, this is a company developing novel therapies for the treatment of sickle cell disease. And this is a huge unmet medical need, affects about 100,000 people in the U.S. And this company had developed a therapy called Oxbryta, which is on the market today. It’s annualizing around $300 million in sales. And this drug actually impacts directly the underlying cause of the disease. It’s actually hemoglobin that ends up polymerizing, and then forming these sickles and it destroys your red blood cells. And so you end up getting anemia, so you get loss of red blood cells, but then you also get ischemia, because sometimes you get clots. And these patients end up in the hospital with pain crises. It’s just a terrible disease.

And so the company came out with this product, and I would say the product is good but it’s not as good as we were hoping it would be. It helps some patients, but probably not all patients. It’s just not potent enough. They have to give too much of it every day, and they’re still not getting enough levels. Now, some companies would have just stopped at that drug, but this company, they kept the research going. They said, “We want to be able to obsolete our own product, and if anyone’s going to do better than this product, we want it to be us.” And so they continue to invest probably $10 million a year on their research programs to see, “Can we come up with an even better product?” And it took many, many years, but they came out with a product that looks like it’s 10 to 20 times more potent than the one that’s on the market today. And it’s a product called GBT601 is the name. And it’s still very early in testing, but it’s now been in patients and it looks to have remarkably better efficacy than the one today. And we thought this could be a game changer product. It’s still very early, so there’s still risk, but if this one pans out, it’s going to be dramatically better and it’s going to help a lot more patients.

And then, Pfizer came along and decided they wanted to buy the company, and so they paid over $5 billion for this company, which had been trading closer to two billion. Interestingly, we thought the company could have been worth even more if they had taken that product further into development. But of course there’s always risk there. But I think the point is the management team was so critical, because had they given up and just said, “We got a product on the market, we’re good,” then this product would never exist. And this product not only created tremendous value for shareholders, but more importantly I think can have a huge impact for patients if it’s successful.

Seides: When you bring all these factors together, your analysis of the science, the business opportunity, management team, how do you and your team go about making decisions about what stocks to put into your portfolios?

Acker: So our team, we’re all located, by the way, in Denver, Colorado, and where we were founded more than 40 years ago. And our team is all together. We meet with each other formally at least once a week, but all of our offices are next to each other. We’re in and out of each other’s offices every day, multiple times a day. We’re on chats constantly. If we think about the portfolio construction, it’s really dependent on two key factors. The first is our conviction. So do we believe we have developed investment insight that the market doesn’t appreciate. And that’s really measured by the discount to intrinsic value. So is this a company that our view is so different than consensus that we have a much higher estimate of intrinsic value than the market? Or it could be the sustainability of the company’s free cash flows. It could be a number of different factors that would make a trade at a discount, but then of course that’s balanced by the risk. So what is the maximum downside if we’re wrong? And in the extreme case, we use the value at risk approach. And so we talked earlier about binary events. So we try to invest sometimes in these binary events where we think that probably the success is much higher than the market appreciates. But we always have to make sure we manage the downside in case we’re wrong. We sometimes have had stocks that could be down 80% in a day. And so the way you manage that is through position size. So for our healthcare strategy, we’re never willing to risk more than 1% of the portfolio, or a hundred basis points on any one event. For a biotech strategy, we give ourselves a little bit more room, but still we’re not willing to risk more than 2% or 200 basis points on any one event. And so we really have to think about that in terms of positioning.

And then, the ones that get into the portfolio, again are the ones that are trading at a big discount to intrinsic value. Where we think that we’ve developed investment insight about the company’s prospects that the market doesn’t appreciate and where the risk is really balanced. So that will determine whether it goes in, and then how big in the portfolio. If we think about the structure of our healthcare strategy, it’s really a barbell approach. So at the top of the portfolio, and especially going into 2022, we were fairly cautious on the market. We could see that inflation was at 40-year highs. We could see that the Fed was behind the eight ball and really was going to need to increase interest rates rapidly. We thought that would be bad for high multiple stocks, longer duration companies where their free cash flow is further out in the future.

And so we got very defensive at the top of the portfolio. We own a lot of, for example, large-cap pharmaceutical companies, large-cap managed care companies, or tools companies. These are companies that are generating tremendous free cash flow that we thought would be relatively insulated in an economic slowing environment and with rising interest rates. And so I think those companies, at least so far through 2022 have held up much better than much of the rest of the market. On the other side, for 23 years we’ve been overweight to biotech in our healthcare strategy… And the reason is it says, Willie Sutton said, “Why do you rob banks? Because that’s where the money is.” We invest in these small and mid-cap biotech companies because that’s where the innovation is. Over 60% of the new medicines that reach the market today were developed by small and mid-cap biotech companies. And if you have a team that can help you identify more of the winners and avoid or mitigate the impact from the losers, you can generate outperformance over many years. So that’s really how we think about it.

Seides: How does that translate into the number of positions you’ll have in your portfolio?

Acker: Yeah. If you think about the portfolio, we’re much more concentrated at the top of the portfolio. So generally, the top 10 stocks are going to be 30, 35% of the portfolio. We typically don’t take enormous positions in one stock. We’ve never taken a 10% position in one company. We want to diversify the risk throughout the portfolio. In the health care strategy, we’re going to have a balance of the different sub-sectors within health care. So we have investments in pharmaceuticals, biotechnology, healthcare services, and medical technology. In the biotech strategy, we don’t want to put all our eggs in one basket. So again, our biggest positions might be five or 6% of the portfolio, then we end up with a fairly long tail of higher risk companies. But those might be in the healthcare strategy, maybe 30 basis point positions. So in healthcare we probably have about 100 stocks in our portfolio, diversified across those four sub sectors. In biotech, it’s probably closer to 50 or 60 stocks, just within biotech where the higher risk names are going to be lower in the portfolio.

Seides: So you mentioned earlier that psychology can play a large role in the pricing of these companies through their volatility. How do you go about trading around positions and factoring in some understanding of the psychology of the stocks?

Acker: Yeah. That’s a good question. So I have a spreadsheet with every stock in our portfolio, and it has what is the current price and what do we think the company is worth. And as you know, these stocks are volatile and biotech stocks are the most volatile. And so they’re constantly trading up and down for often insignificant reasons. And so what we look at is how much upside is there to our estimate of intrinsic value. And so if you have a stock that’s pulling back and we think it’s not for a valid reason that actually changes the value of the company, then we would be adding to that position.

And similarly, sometimes your stocks become in favor and the market loves them and the companies go up. And sometimes they approach or reach our estimate of intrinsic value, in which case as it approaches our estimate of intrinsic value, we’re generally trimming into that strength. And if it reaches or exceeds our estimate of intrinsic value, then we generally be selling that stock. So there’s a constant rebalancing in the

portfolio where we’re trying to maximize the risk adjusted return potential at any time. The volatility in the market we try to use to our advantage to add to the ones that are weak that we still like, and trim the ones that are really strong that we think are starting to approach fair value.

Seides: Now, how do you incorporate private investments into your portfolios?

Acker: Yeah. So we’ve actually been investing in private companies as part of our health care strategy for more than 18 years now. And we think it gives us a big advantage because we consider ourselves crossover investors. A crossover investment is one where you’re investing in a private company generally within a year of when you think it can go public. And so the advantage there is a lot of the innovation in the sector comes from private companies. And we want to get an early look into those companies because some of them may be very exciting investments on their own. And as an example, BioNTech, which is the company that made the first mRNA vaccine along with Pfizer, we invest in that company when it was still a private company back in 2017 when most people had never heard of mRNA. So we got a very early look into companies like that.

And back then, their company had a $2 billion market cap; in 2021 it got to $100 billion market cap. But on the other hand, you also want to get visibility into the potential disruptors because they can have an impact on your large public companies. They might be a competitive product that could be superior to the current standard of care. So getting that visibility from an early stage is extremely helpful to the entire process and having a holistic view of the whole sector. We’ve made money more than two thirds of the time in those private investments.

Seides: As you’re looking at all the activity that’s happening in the private companies as well as a public stocks. What are the, thematically, the opportunities that you’re most excited about?

Acker: As I mentioned earlier, we’re seeing incredible innovation in the sector. And so we’re focused on these companies that can address high unmet medical needs. And one of those areas we’re really excited about is new gene-based therapies. So historically we would give a small molecule, maybe try to block a protein. But when you give a gene therapy, you have the potential with a single treatment to address an underlying genetic defect. There are 7,000 genetic diseases and 95% of them have no available treatment today. So we’re aware of these devastating genetic diseases that can have a dramatic impact on quality of life and survival, and yet there’s nothing we can do about them. But now, we know exactly which gene is defective, we know a gene gets translated into RNA, which then becomes a protein, sometimes that protein is defective and the defective protein is causing problems, sometimes it’s missing.

But we have new ways now of doing everything from replacing a defective or missing protein. So you could think about factor eight for hemophilia or replacing dystrophin for patients with muscular dystrophy. We think this is incredibly exciting. And these therapies, they’re here now. So we have a gene therapy for hemophilia approved in Europe. In 2023, we could have the first gene therapy for muscular dystrophy. They’re also working on gene therapies essentially for sickle cell disease. We have other diseases that affect tens of millions of people that we have no treatment for. Another one that we’re excited about is called NASH, which actually stands for nonalcoholic steatohepatitis, which is definitely a mouthful. But what that means is these patients have fatty liver disease. And this affects tens of millions of people in the US whose livers are getting partially replaced with fat, and then that fat leads to inflammation, which eventually can lead to fibrosis and cirrhosis where you have a failed liver, and then that leads to either liver transplant or liver cancer or death.

This is becoming the leading cause of liver failure in the United States. And companies have been trying for years and years to develop a therapy that could actually have an impact on this disease and it’s been very difficult. But just recently we had a company that developed a therapy that after six months of a once weekly injection, they were able to resolve this NASH in 77% of patients. So this is a dramatic benefit. So we’re starting to get therapies for the first time that actually can be effective for this disease that can actually reverse fibrosis in the liver. So we think this could be a big market. Obesity is another huge unmet medical need affects a hundred million people in the US, 500 million people worldwide. And the old therapies that we used to use were only moderately effective. They could give you maybe mid-single-digit weight loss and some of them had toxicity, they could cause heart damage. So those never really did that well. But it remains a huge unmet need. And when you have obesity, it leads to an increased rate of virtually every other disease from cardiovascular disease to cancer to kidney disease to liver disease. So huge problem. We’re now getting new therapies that are called incretin-based therapies. These are gut hormones that actually signal satiety, they basically say, “Stop eating because you’re full.” The problem is those only happen when you eat and they only last for minutes. But now we’re developing extended-release versions of those hormones that in some cases are leading to 15 to 20% type of weight loss. That’s on par with what you get with bariatric surgery, which we know can dramatically improve outcomes. And so we’re starting to get these therapies now that have dramatically more weight loss and this could represent a huge market opportunity if they can improve outcomes.

Seides: What do you see are some of the biggest risks to the space?

Acker: Yeah. So one of the risk that I think investors generally worry about when you think about healthcare, and especially therapeutics and medicine is the price of medicine. And that’s become more and more of an issue, especially in the United States. Today, about a third of patients don’t fill their prescriptions because of the copays that they can’t afford. And so that’s become a more and more sensitive political issue. And just recently we had passage of what was called the IRA or the Inflation Reduction Act. And that was for the first time in more than 25 years of trying, something was passed to try to address drug pricing. And it had several elements to it that we thought were actually quite positive. One, for example, is it limits the amount of out-of-pocket spending for seniors to know more than $2,000 per year.

In some cases, seniors were having to pay five to $10,000 out of pocket for a life-saving medicine, and that should never happen. So that we think was a positive aspect. Another aspect is it would limit drug pricing for Medicare patients to know more than inflation. We think that was a pretty reasonable approach. And the third and most controversial element was essentially what was called drug price negotiation. And so the initial proposals we thought would’ve been very harmful for the industry, that’s created a lot of fear, partially responsible for causing the bear market and biotech we think. What they ended up with we think was mostly manageable, and so what they said is, “We’re going to negotiate on some of the highest spending drugs in Medicare, but only after nine years for oral therapies and only after 13 to 15 years for biologics.”

And so for biologics, that means generally we’ll start negotiating only around when the patents are going to expire anyway. And so the impact really isn’t that great, and we think that’s actually a fair approach. Because what you want to avoid is the outliers, the drugs that stay on the market for 20 years, and that the government and commercial payers are paying billions of dollars a year for very old innovation, that should be avoided.

Seides: In what’s been a really tough bear market for the space. What are you looking at to see when the tide is turning?

Acker: Yeah. So we put out a newsletter recently that we called Green Shoots for our biotech strategy. And we have seen signs that the market for biotech stocks may have bottomed in June. And what did we look for? So one is good clinical data being rewarded by the market and we’ve seen that. So we’ve had companies reporting positive data and the stocks going up, and then importantly they’ve been able to finance on that. Some of them have been raising hundreds of millions of dollars overnight, and then in many cases the stocks would go up after they raise money. So that is a very healthy sign of innovation being rewarded. The second factor that we thought would pick up is M&A activity. And why do we say that? Because if you think about the top 20 major biopharmaceutical companies, many of them are facing substantial patent expirations later this decade. And in some cases they’re going to be losing up to half of their revenue. And so in order to replace that, they’re going to need to do business development to add new innovative products. And at the same time you have the market that has traded down and lost 70% of its value. You have these companies that by the end of 2022 are estimated to have 500 billion in cash on their balance sheets. And even just Pfizer alone has said that they need to make acquisitions to acquire $25 billion of revenue by the end of 2030. So one of the things we were looking for is a pickup in M&A activity, and we actually have seen that. Just in the last few months we’ve had multi-billion-dollar deals.

Seides: Great. Andy, before I let you go, I need to ask you a couple of fun closing questions. So what is your favorite hobby or activity outside of work and family?

Acker: I would have to say a few, traveling, tennis, and skiing.

Seides: Works in Colorado, I guess. Certainly the skiing.

Acker: We have great skiing out here.

Seides: What’s your biggest investment pet peeve?

Acker: I’d have to say when management teams over-promise and under-deliver. And also, I guess, when management teams lie to you, that’s incredibly frustrating.

Seides: Yeah. How about generally, what’s your biggest pet peeve in life?

Acker: I’d say it’s people that are rude. There’s no reason not to have good manners.

Seides: Which two people have had the biggest impact on your professional life?

Acker: I’d say the first one was my father who actually introduced me to investing at the tender age of eight. He was a physician but also was an investor on the side. So he got me into biotech investing way back in 1980, and so he had a big impact on me. And then, the second one would be Tom Malley who brought me to Janus Henderson back in ’99, and taught me how to be an analyst and a portfolio manager in the health care sector.

Seides: What type of investment do you gravitate to like a moth to a flame?

Acker: Yeah. I think sometimes the best ideas are the ones that seem the most painful at the time. And often, for example, in drug development, it’s not a straight line to success, you often have setbacks along the way. What we find is when a company has, for example, a failed phase two study, the stock can get

absolutely crushed and the market sometimes treats that company as if the product were dead. And not only that product, but the entire pipeline was worthless. And just one good example, recently, Sarepta Therapeutics, that company developing a gene therapy for muscular dystrophy. That gene therapy had a failed phase two study in January of 2021, the stock was down 50% in a day. But we looked at and we thought that product still had substantial promise. We thought we could figure out why that study had failed, and if you can come back and then ultimately be successful, those are often the best investments. So it’s really buying when a company is the most controversial, the most hated, but where you have high conviction that a product really works.

Seides: What teaching from your parents has most stayed with you?

Acker: Yeah. Again, I would say my father always talked about the world is full of brilliant failures. And he said, “You really have to put an effort behind it and you have to do your best in everything,” and that’s really stuck with me.

Seides: Great. Andy, last one. What life lesson have you learned that you wish you knew a lot earlier in life?

Acker: Well, I’d have to say, don’t sweat the small stuff, and it’s something I still work on. But that 80/20 rule I think applies for so many things in life. I always struggle with it because I’m very detail oriented. But when you can apply it, it’s incredibly helpful to save a lot of time.

Seides: Andy, thanks so much for sharing this really interesting opportunity with us.

Acker: Thanks for having me, Ted.

Seides: Thanks for listening to the show. If you like what you heard, hop on our website at capitalallocators.com where you can access past shows, join our mailing list, and sign up for premium content. Have a good one and see you next time.