Ardent value investor Seth Klarman is swapping out shares of search engine juggernaut Alphabet for
a relatively unknown pharmaceutical stock that has a forward price-to-earnings ratio of 5!
Earnings season has officially kicked off for Wall Street. Over a roughly six-week stretch, a majority of S&P 500 companies will report their operating results from the latest quarter and offer insight on the health of the U.S. economy and consumer.
But earnings season is far from the only important data dump investors are privy to each quarter.
On Aug. 14, institutional investors with at least $100 million in assets under management were required to file Form 13F with the Securities and Exchange Commission. This invaluable filing allows investors to see what Wall Street’s smartest money managers bought and sold in the latest quarter.
To be transparent, 13Fs aren’t perfect. They can be 45 days old, when filed, which means they’re presenting stale information for active hedge funds. Nevertheless, 13Fs provide insight into which stocks, industries, sectors, and trends are piquing the interest of Wall Street’s most-prominent asset managers.
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The June-ended quarter was a particularly active period for billionaire Seth Klarman, the CEO and portfolio manager of Baupost Group. The value-focused Klarman, who’s modeled his investment philosophy after Benjamin Graham, is overseeing $3.6 billion of invested assets spread across close to two dozen holdings.
Perhaps the most noteworthy move made by Klarman in the second quarter was to meaningfully pare down the cheapest of all “Magnificent Seven” stocks, Google parent Alphabet (GOOGL -1.35%) (GOOG -1.34%). At the same time, Klarman willingly piled into an off-the-radar, but historically inexpensive, drug stock.
Klarman’s Baupost jettisoned a significant portion of its stake in Alphabet
Baupost first initiated a position in Alphabet’s Class C shares (GOOG) during the first quarter of 2020 (i.e., during the COVID-19 crash). As of March 31, Klarman’s fund held north of 2.9 million shares. But over the course of three months, ended June 30, Baupost’s investment leaders, including Klarman, sent 1,888,064 shares of Alphabet to the chopping block, representing a 64% reduction.
While profit-taking is a viable reason for Seth Klarman and his team to reduce their fund’s stake in Google, YouTube, and Waymo parent Alphabet by nearly two-thirds, I believe there may four other possible explanations.
To start with, Klarman and his crew might be concerned about the stock market being historically pricey. The S&P 500’s Shiller price-to-earnings (P/E) ratio, which is commonly referred to as the cyclically adjusted price-to-earnings ratio (CAPE ratio), hit its highest level of the year earlier this week (37.70), and has more than doubled its average reading of 17.16, dating back to January 1871. Even though Alphabet’s forward P/E ratio is a reasonably low 19, the company’s shares would undoubtedly be weighed down if the broad-market indexes were to roll over.
Alphabet’s valuation might be another tipping point for Baupost’s chief. Despite Alphabet’s stock trading below its average forward P/E multiple over the last five years, it’s pricier than its average book value over the last five years, and is no longer the screaming bargain it’s been relative to its cash flow. Klarman tends to focus heavily on these traditional fundamental measures of value.
A third possibility behind this aggressive selling activity in Alphabet’s Class C stock is the potential for the U.S. to fall into a recession. The first notable decline in M2 money supply since the Great Depression, along with the longest yield-curve inversion in history, suggest the U.S. economy can stumble in the coming quarters. With Alphabet generating 76% of its net sales from advertising during the June-ended quarter, it would be susceptible to weakness if economic growth were to slow or shift into reverse.
Lastly, Baupost Group’s smartest investment minds may have foreseen legal troubles to come for Alphabet. Specifically, the U.S. Justice Department may seek a breakup of Alphabet due to its utter dominance of internet search. Uncertainty tends to be the enemy of investors.
For what it’s worth, I believe this is a decision Klarman will eventually regret. But with the stock market historically pricey and Klarman being an ardent value investor, this selling activity does makes sense.
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Klarman is scooping up shares of a jaw-droppingly cheap pharma stock
On the other end of the spectrum, Klarman and his team added to nine of Baupost Group’s existing positions during the second quarter. Arguably none of these purchases stands out more than drug developer Jazz Pharmaceuticals (JAZZ -0.88%).
During the June-ended quarter, Klarman oversaw the addition of 440,552 shares of Jazz, which increased his fund’s stake in the company by 53% to 1,274,248 shares. As of the midpoint of 2024, Jazz Pharmaceuticals was Baupost’s ninth-largest holding, worth $136 million.
Jazz’s oxybate franchise, which is comprised of Xyrem and Xywav (two therapies focused on treating sleep disorders), are what make the company tick. Xyrem was Jazz’s blockbuster narcolepsy treatment, while Xywav is its next-generation sleep-disorder therapy. Xywav contains 92% less sodium than Xyrem, which makes it an ideal sleep-disorder therapy for people with cardiovascular concerns. Based on revenue through the first-half of 2024, Jazz’s oxybate franchise is pacing $1.6 billion in sales for the current year.
Jazz is also looking for its cannabidiol (CBD)-based therapy, Epidiolex (known as Epidyolex overseas), to eventually reach blockbuster status. Epidiolex was the crown jewel of the $7.2 billion GW Pharmaceuticals acquisition by Jazz in May 2021. It treats rare forms of epilepsy and has limited competition, which has paved a path to steady double-digit sales growth. Epidiolex looks to be on track to generate close to $900 million in full-year revenue in 2024.
Furthermore, Jazz’s oncology segment topped $1 billion in annual sales for the first time in 2023. Much of this growth was fueled by injectable therapy Rylaze, which is a treatment for acute lymphoblastic leukemia and lymphoblastic lymphoma. Improved cancer-screening diagnostics and substantive pricing power should lift oncology segment sales to at least $1.1 billion this year.
Despite steady long-term growth from all three facets of the company’s drug portfolio, there’s concern that Avadel Pharmaceuticals may eat into Jazz’s dominance of the sleep disorder space. Avadel commercially launched Lumryz in the U.S. five months ago, which is a therapy that directly competes with Jazz’s oxybate franchise in select indications.
However, a strong argument can be made that these competitive concerns are fully baked in. Shares of Jazz are valued at a little over 5 times Wall Street’s consensus earnings per share (EPS) forecast for 2025. This represents a 32% discount to the company’s average forward P/E over the trailing-five-year period.
What’s more, Jazz Pharmaceuticals has a robust pipeline that currently features more than 30 clinical trials. While there are a handful of label expansion opportunities for Epidiolex, the company’s future revolves around its oncology pipeline, which is targeting small-cell lung cancer, breast cancer, and acute myeloid leukemia, among other indications. Just a few wins among these 30-plus trials can be huge for Jazz.
