INSP - Headwaters Capital Q3 2023 Investor Letter
2023-11-08 04:55:00 ET
Summary
- Headwaters Capital Management is an actively managed, concentrated investment strategy focused on small and mid-capitalization stocks.
- Headwaters Capital Management's portfolio declined by 7.6% in Q3 2023, compared to a 4.7% return for the Russell Mid Cap Index.
- Rising bond yields and the perceived threat of GLP-1 weight loss drugs impacted broad equity market performance.
- Headwaters Capital continues to oppose Danaher's proposed acquisition of Abcam, believing the offer undervalues the company.
Dear Investors,
The Headwaters Capital Management, LLC (“Headwaters Capital,” “Headwaters,” or the “Firm”) portfolio declined -7.6% (-7.8% net) for the third quarter of 2023 compared to a -4.7% return for the Russell Mid Cap Index. YTD performance for the Headwaters portfolio stands at +14.2% (+13.5% net) compared to a +3.9% return for the Russell Mid Cap Index. A brief discussion of the performance and trading activity during the quarter is presented below as well as an update on Danaher’s proposed acquisition of Abcam.
Headwaters Capital Returns:
| Q1 '23 |
| Q2 '23 |
| Q3 23 |
| YTD '23 |
| LTM (9/30/23) |
| 2021 |
| 2022 |
| Since Inception (1/4/2021) |
| Headwaters Capital (Gross) |
| 5.2% |
| 17.4% |
| -7.6% |
| 14.2% |
| 22.4% |
| 17.9% |
| -22.7% |
| 4.0% |
| Headwaters Capital ((net)) |
| 5.0% |
| 17.2% |
| -7.8% |
| 13.5% |
| 21.5% |
| 17.1% |
| -23.4% |
| 1.8% |
| Russell Mid Cap Index |
| 4.1% |
| 4.8% |
| -4.7% |
| 3.9% |
| 13.5% |
| 22.6% |
| -17.3% |
| 5.3% |
| *Performance for the Headwaters Capital portfolio has been calculated by Liccar Fund Services for the period presented above. **Individual SMA performance may differ from the results presented above. 1 The composite performance (“portfolio” or “strategy”) is calculated using the return of a representative portfolio invested in accordance with Headwaters Capital’s fully discretionary accounts under management opened and funded prior to January 1, 2021. The performance data was calculated on a total return basis, including reinvestments of dividends and interest, accrued income, and realized and unrealized gains or losses. The returns also reflect a deduction of advisory fees, commissions charged on transactions, and fees for related services. For further information about the total portfolio’s performance, please contact Headwaters at the email address listed. |
Q3 2023 Performance Discussion
Two themes dominated broad equity market performance during Q3 ’23. The first theme was rising bond yields, which pressured valuations across all asset classes during the quarter. The US 10-year Treasury yield increased 75 bps during the quarter (and has increased another 45 bps so far in Q4), driving markets lower as discount rates increased. The second important theme was the perceived threat of GLP-1 weight loss drugs to a number of business models, but most acutely, healthcare companies (the Russell 2000 healthcare sector declined -15.1% in Q3). Healthcare stocks were negatively impacted as investors fear that the increasing adoption of weight loss drugs will lead to lower levels of obesity and a corresponding decline in broad medical treatments and procedures. This theme reverberated throughout the markets during Q3 as investors wrestled with the potential implications of widespread and durable weight loss drug adoption. HCM’s exposure to healthcare stocks drove the underperformance relative to the index and was concentrated in two stocks ( INSP , UFPT ) discussed below.
My optimistic outlook for small caps has not changed since Q2. What has changed since the presentation in May is the rapid rise in long-term treasury yields. In light of the recent move in yields, it’s helpful to put current valuations in historical context given renewed fears around bond yields and appropriate multiples. As shown on the following page, current small cap valuations are below trough levels seen throughout 2000-2007, a period of time when bond yields fluctuated between 4-5%, or similar to today’s yields. The implication is that the small cap part of the market has largely priced in the current move in bond yields and, has potentially overshot the valuation reset (the Russell 2000 has declined -17% from 7/31/23-10/26/23). For anyone who is interested in taking advantage of the recent weakness or learning more about Headwaters Capital, please contact me directly.
Abcam Update
In lieu of any new portfolio additions this quarter, I wanted to provide an update on Danaher’s ( DHR ) proposed acquisition of Abcam, which Headwaters Capital continues to oppose. Hopefully most investors saw th e initial letter to shareholders on 9/21/23 outlining why Headwaters Capital is opposed to the transaction. On October 18, 2023, Headwaters released a follow-up letter in response to Abcam’s Independent Directors’ Q&A about how they arrived at the recommendation to sell to Danaher at a $24 price.
Since the October letter was released, both DHR and Thermo Fisher ( TMO ) have reported Q3 earnings. While these bellwether life science peers are dealing with COVID revenue declines, bioprocessing weakness and general declines in capital equipment spending that are negatively impacting their revenues and the broader life sciences tools industry, ABCM, on the other hand, has minimal exposure to any of this end market weakness. Instead, as noted by both DHR and TMO, the academic, government and life sciences end markets where ABCM is concentrated, continue to perform well.
"Now if you think about this by end market, academic and life science research have held up well." – Source: DHR Q3 2023 Conference Call
"In academic and government, we grew in the high single digits in the quarter. " - Source: TMO Q3 2023 Conference Call
Headwaters Capital continues to believe that DHR’s offer of $24 per share materially undervalues ABCM as the purchase price does not reflect future revenue growth and margin improvement. A detailed discussion of financial assumptions and relevant trading multiples is discussed in the October letter to shareholders.
Q3 ’23 Portfolio Review
Top Contributor: Qualys ( QLYS ) +18%: Qualys reported better than feared Q2 results as bookings were ahead of forecast. Despite broad IT budget pressure, cyber-security spend continues to be a priority for companies as global cyberattacks continue to proliferate. Additionally, M&A in the software space has provided valuation support for QLYS given the company’s strong free cash flow profile and net cash position.
Top Detractor: Inspire Medical ( INSP ) -39% : Inspire Medical was squarely in the cross-hairs of the weight loss drug fears during Q3. Investors are concerned that weight loss drugs will result in lower levels of obesity, the leading cause of sleep apnea, which will negatively impact INSP’s sales. I believe this is a case of “shoot first, ask questions later” given that the ultimate impact is likely years away. However, I believe INSP is insulated from the GLP-1 fears even if there is broad adoption of these drugs. INSP’s neurostimulation device for treating sleep apnea is not approved for patients with a body mass index (“BMI”) > 40. As it stands today, there is a large population of CPAP patients that cannot be treated by INSP due to this label indication. If these patients with a BMI > 40 begin taking weight loss drugs and reduce BMI into the target indication range, this will add a new population of patients that INSP can treat. While INSP’s sales funnel will also lose some patients who no longer need INSP therapy thanks to weight loss drugs, the net result is likely neutral to positive for INSP. Time will ultimately tell how this plays out, but I do believe current fears are overblown.
A quick note on UFPT, which was also impacted by weight loss drug fears and declined -16.7% during the quarter.
A significant portion of UFPT’s revenue is tied to single-use sterile drapes that are used as part of Intuitive Surgical’s da Vinci robots. There is concern that lower levels of obesity will result in lower robotic surgery procedures, specifically bariatric procedures. Bariatric procedures account for ~5% of da Vinici procedures, so the ultimate impact to ISRG and, by association, UFPT is likely to be minimal even if there is widespread adoption of these drugs.
Trading Activity
Buys: Added to multiple existing positions during the quarter.
Sells: CYRX
Cyroport was sold during the quarter due to concerns that cell and gene therapy commercialization will continue to be slower than forecast.
As always, if you have any questions about the portfolio or the market, please do not hesitate to contact me.
Christopher Godfrey
| The views expressed herein are those of Headwaters Capital as of the date hereof and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. These views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. This piece is for informational purposes and should not be construed as a research report. Headwaters Capital conducted its own analysis based upon information available to it at the time of the analysis which may change at any time without notice and does not make any warranty as to the accuracy or completeness of any analysis, data point, assumption or opinion presented herein. Important DisclosureThis report is for informational purposes and shall not constitute an offer to sell, or a solicitation to buy, any security, product, or service from Headwaters Capital. The opinions expressed herein represent the current views of Headwaters at the time of preparation and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this report has been developed internally and/or obtained from sources believed to be reliable; however, Headwaters Capital does not guarantee the accuracy, adequacy, or completeness of such information. Predictions, opinions, and other information contained in this report are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made in this report, and the Firm assumes no duty to the reader to update forward-looking statements or any other information provided in this report. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements. In particular, target returns are based on the Firm’s historical data regarding asset class and strategy. There is no guarantee that targeted returns will be realized or achieved or that an investment strategy will be successful. Individuals should keep in mind that the securities markets are volatile and unpredictable. Therefore, investing in securities or other types investment products involve a high degree of risk. There are no guarantees that the historical performance of an investment, portfolio, investment product, fund, or asset class will have a direct correlation with its future performance, and past performance does not guarantee future results. The composite performance (“portfolio” or “strategy”) is calculated using the return of a representative portfolio invested in accordance with Headwaters Capital’s fully discretionary accounts under management opened and funded prior to January 1, 2021. The performance data was calculated on a total return basis, including reinvestments of dividends and interest, accrued income, and realized and unrealized gains or losses. The returns also reflect a deduction of advisory fees, commissions charged on transactions, and fees for related services. For further information about the total portfolio’s performance, please contact Headwaters at www.headwaterscapmgmt.com or via phone at (404) 285 -0829 Investing in small- and mid-size companies can involve risks such as less publicly available information than larger companies, volatility, and less liquidity. Investing in a more limited number of issuers and sectors can be subject to greater market fluctuation. Portfolios that concentrate investments in a certain sector may be subject to greater risk than portfolios that invest more broadly, as companies in that sector may share common characteristics and may react similarly to market developments or other factors affecting their values. Headwaters Capital is a registered investment adviser doing business in Texas and Georgia. Registration with any state regulatory agency does not imply a certain level of skill or training. For additional information about Headwaters Capital, including its services and fees, please review the firm’s disclosure statement as set forth in the Firm’s Form ADV and is available at no charge at IAPD - Investment Adviser Public Disclosure - Homepage. |
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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Headwaters Capital Q3 2023 Investor Letter