What to Buy: H&Q Life Sciences Investors (NYSE: HQL)

Why to Buy Now: HQL is a closed-end fund (CEF) that specializes in the biotechnology sector. As such, it offers investors the potential for long-term growth with a substantial income kicker via its 7.1 percent distribution rate.

While the fund invests primarily in equities, it also has a venture capital sleeve where it can invest in development-stage companies that have yet to go public. That definitely differentiates it from the average healthcare fund.

Fortunately, management knows how to navigate this risky space. The lead manager boasts both impressive academic credentials along with extensive industry expertise. And he’s been at the helm for well over a decade. Other members of the management team have similar backgrounds and longevity with the fund.

This rare combination of experience and financial acumen has translated into an impressive performance in recent years, with the portfolio gaining 32.6 percent over the past three years.

Despite the fund’s success, we’ll be able to buy our shares at a nearly 4 percent discount to net asset value. Buy HQL below 19.77.

Ari: Healthcare plays are compelling investments not just because of their defensive properties in a volatile market, but also because of their demographic destiny. As millions of Baby Boomers age, healthcare firms should benefit from their outsize demand.

However, H&Q Life Sciences Investors (NYSE: HQL) is very different from the average healthcare fund. First, it largely specializes in the biotechnology sector, so its investments are generally riskier than some of the more traditional healthcare stocks.

And because it’s a closed-end fund (CEF), HQL has fewer constraints on its investments than a traditional mutual fund. For instance, HQL is permitted to invest up to 40 percent of its assets in venture or restricted securities. In other words, the CEF not only invests in cutting-edge stocks, it also has a venture-capital sleeve that offers exposure to firms that may not even be public yet.

Since we assumed the helm at Big Yield Hunting back in May, our approach has generally been to find securities that are among the least risky of the otherwise extraordinarily risky high-yield space.

Our assumption has been that most subscribers are here for the income from high yields, rather than to suffer the extreme risk/reward possibilities of beaten-down stocks and other turnaround plays. By the way, if we’re wrong about that, you have the opportunity to enlighten us via a subscriber survey that’s linked just below this article.

Anyway, we’ve been looking for securities with moderate growth that have the ability to sustain their payouts in most environments. But there aren’t an infinite number of such plays, so sometimes we’ll have to do things a bit differently. In the case of HQL, its specialty in a growth-oriented subsector means that this is a security with high long-term growth potential that just happens to have a strong income kicker.

Khoa: Finally, a security that really gets the blood racing! But before we delve into it in greater detail, how about a quick refresher on CEFs?

Ari: Sure. Although CEFs have many similarities to mutual funds and exchange-traded funds (ETF), they are actually distinct from both. CEFs have actively managed portfolios like most mutual funds, but they trade on exchanges like ETFs. Unlike mutual funds, CEFs are permitted to use leverage, but fortunately this fund does not currently employ leverage to enhance its returns.

While the structure of ETFs enables them to track their net asset values (NAV) closely, CEFs can trade at prices that deviate widely from their NAVs. In this case, H&Q Life Sciences currently trades at a nearly 4 percent discount to its NAV.

In fact, many CEFs trade at persistent discounts to their NAVs. However, such discounts allow value-conscious investors to purchase assets cheaply relative to their market value. Over the past three years, for instance, HQL’s average discount to NAV was 6 percent, while over the past six months, it traded at a modest 0.4 percent premium to NAV.

Additionally, CEFs often make efforts to reduce these discounts for their shareholders. In previous years, HQL has made tender offers to buy investors’ shares back at a premium to the market price. In March, the fund’s trustees approved the renewal of a share repurchase program that allows the fund to buy back up to 12 percent of its outstanding shares for a one-year period that commenced in July.

Khoa: What does the portfolio look like?

Ari: At the end of June, the fund’s equity sleeve accounted for 83.5 percent of assets. Biotech stocks, including well-known names such as Gilead Sciences (NSDQ: GILD) and Celgene Corp (NSDQ: CELG), were nearly 60 percent of assets. Additionally, the fund had an 11 percent allocation to generic pharmaceutical firms, a 6.1 percent allocation to regular pharmaceutical companies, an almost 4 percent allocation to medical device companies, and even smaller allocations to drug discovery and drug delivery firms.  

Almost a third of the fund’s equity sleeve was allocated toward small- and mid-cap stocks. And the fund also had a substantial 12.7 percent allocation to micro-cap stocks–stocks that generally have market capitalizations below $300 million. The average market cap of the fund’s equity investments is $9.6 billion, which is near the upper threshold of the mid-cap range.

And the fund bets heavily on its favorites, with 48.3 percent of assets in its top 10 holdings.

But one of the chief attractions of this fund’s portfolio is its venture capital sleeve. As mentioned earlier, the fund’s charter allows it to invest up to 40 percent of its portfolio in the venture financing it provides to both public and private firms.

At the end of June, however, this sleeve, which includes investments in convertible preferreds and warrants, comprised a relatively modest 9.1 percent of net assets. The portfolio also has a 1.9 percent allocation to two milestone interests, which pay a royalty when a company achieves certain sales thresholds with its products.

Investors should be aware that these venture capital investments are illiquid securities whose risk does offer high rewards, but can occasionally result in total wipeouts should any of the firms enter bankruptcy.

The fund’s annual turnover has averaged 76.2 percent over the past three years, which is not uncommon when you’re dealing with growth stocks.

Khoa: What about the management team? I’m assuming these are no mere armchair analysts.

Ari: Ahem. Like us, you mean? No, the two principal portfolio managers both have PhDs and extensive industry experience. Lead manager Daniel Omstead was previously president and CEO of a development-stage biotech company that specialized in regenerative medicine, and prior to that spent 14 years in the pharmaceutical industry.

And Frank Gentile worked in both the pharmaceutical and biotech industries and holds 30 US patents in the biotech realm. Both have been with the fund for well over a decade and work alongside two other analysts with similar backgrounds and longevity with the fund.

It’s worth noting that the fund’s expense ratio for the most recent six-month period was 1.56 percent, while its annual expense ratio for the prior year was 1.72 percent.

Khoa: The fund’s performance data are pretty impressive. I guess management has earned their cut.

Ari: Indeed! It helps when you partner with a management team that has the rare combination of financial acumen and industry expertise.

Over the trailing 10-year period, HQL gained 10.1 percent annually on an NAV basis and 11.3 percent annually on a price basis. But the pace of its returns has been absolutely torrid over the past few years, with a 32.6 percent annualized gain over the past three years on an NAV basis and a 39.6 percent return on a price basis.

Part of that performance has been driven by a strong tailwind from the biotech sector in general. And management is wary that this hot hand could eventually cool, though for now they believe the sector could have further upside.

They characterize the biotech sector as entering a more mature phase, where many firms have transitioned from the development stage to bringing actual revenue-generating products to market. For instance, as of 2012, six of the top-selling drugs had an origin in biotech. This success has attracted additional investor interest, which has helped support valuations.

Finally, the regulatory environment is surprisingly accommodative, as the Food and Drug Administration has made great strides toward streamlining approvals of new drugs.

Although caution is certainly warranted after a strong run, at the very least, we’ll be purchasing shares of this CEF at a discount to NAV.

Khoa: HQL has a current distribution rate of 7.1 percent. How does it have such a high payout when many of these firms don’t even pay dividends?

Ari: HQL has a managed distribution policy under which it makes a quarterly payout that’s equivalent to 2 percent of net assets. Its distribution can consist of short- or long-term capital gains, dividends from equity investments, interest from fixed-income investments, and occasionally the dreaded return of capital.

So the tax consequences of the fund’s distributions will vary over time. In exchange for minimal to no taxation at the fund level, CEFs must distribute at least 90 percent of their net realized capital gains and at least 98 percent of their net investment income to shareholders each year.

Over the past four quarters, for instance, two distributions were derived from long-term capital gains and two distributions were derived from short-term capital gains. Obviously, the former are more advantageous from a tax perspective. Distributions sourced from short-term capital gains or investment income will be taxed as ordinary income.

As we discussed in a previous recommendation, many CEFs entice investors with high distributions that can only be maintained via regular destructive returns of capital, a Ponzi-like scenario where investors are basically getting their own money back net of management fees.

However, not all returns of capital are bad. For instance, when a return of capital is based on unrealized capital gains and is, therefore, paid out from a fund’s cash balance, that typically means management is attempting to let its winners run, rather than liquidate them to meet short-term obligations.

To determine whether a return of capital was destructive, compare a fund’s calendar-year return on NAV to its total distribution. If the fund’s year-end NAV net of the distribution is lower than where it began the year, then the return of capital was likely destructive.

But even the occasional destructive return of capital is permissible as long as management doesn’t make a habit out of it. They may have erred in projecting their payouts or the market may have suffered a short-term dislocation that eroded a portion of the payout.

And if the fund trades at a discount to NAV, then even a destructive return of capital can enhance returns if investors participate in a fund’s distribution reinvestment program. Regardless of whether they’re good or bad, returns of capital are not taxable and serve to reduce an investor’s cost basis.

According to the fund’s distribution history, return of capital has been a component of HQL’s distribution just twice–during the first and second quarters of 2009, at the height of the Great Recession. As such, it’s entirely understandable that the fund would return capital to shareholders under such challenged circumstances.

As further evidence of the extraordinary nature of that time period, the fund actually suspended its distribution for three consecutive quarters thereafter, finally reinstating its payout in the second quarter of 2010. Prior to that, the fund paid distributions for 35 consecutive quarters.

So we have no doubt about management’s commitment to the distribution. And we’re betting that a downturn of the magnitude that occurred during that period is a generational event that hopefully won’t be reprised anytime soon.

Finally, it’s important to note that HQL defaults to paying distributions in the form of additional shares. While reinvesting shares of the fund will boost returns over time, investors who’d prefer to receive cash payouts must specify this preference with the fund or their brokerage. The Fund’s transfer agent delivers an election card and instructions to each registered shareholder in connection with each distribution.

CEFs have lower average trading volumes than equities, so it’s best to use buy limits when buying or selling shares of HQL. Beyond that, investors should attempt to buy CEFs at discounts to their net asset value. HQL currently trades at nearly a 4 percent discount to NAV, so we’re setting our buy target based upon a 3 percent discount to the fund’s NAV on Sept. 19, which was $20.38. Buy HQL below 19.77.

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Portfolio Updates

Aditya Birla Minerals Ltd (ASX: ABY, OTC: ABWAF) reported a 1 percent rise in fiscal 2013 revenue, to AUD502.3 million, but a net loss of AUD8.3 million.

Ore processed at its Nifty and Mt. Gordon mines rose 22 percent year over year, to 3.4 million tonnes. Copper production increased by 16 percent, to 69,291 tonnes.

The cost per pound of copper rose by AUD0.05 year over year, to AUD2.50. Management forecasts a more significant jump in costs, to AUD3.15, during the first quarter of fiscal-year 2014, as a result of declining production due to falling copper grades.

Aditya expects to produce 48,000 tonnes to 52,000 tonnes of copper from its Nifty operations in fiscal-year 2014, compared to the 49,188 tonnes it produced the prior year. It did not provide guidance for Mt. Gordon, as it’s undertaking a strategic review of these assets.

Although 2013 production increased, copper prices continue to remain depressed due to supply exceeding demand amid a sluggish global economy. However, a declining Australian dollar should help boost earnings, while enabling the company to be more competitive globally.

The company did not declare a dividend for fiscal-year 2013, so it’s now essentially a play on a turnaround in the global copper market. Should that market weaken further, we’ll be inclined to sell this position. For now, Aditya remains a hold.

On Aug. 28, John Hancock Premium Dividend Fund (NYSE: PDT) reported that net investment income per share grew 9.8 percent sequentially, to $12.4 million, or $0.247 per share, for the three months ended July 31. Total managed assets grew by 5.4 percent, to $1.1 billion.

Although the closed-end fund’s (CEF) unit price was already down significantly by the time we recommended it, PDT has suffered a further decline of 9 percent since then versus 6.7 percent for the net asset value of its underlying portfolio.

We recommended this CEF for two reasons:

For one, we wanted to take advantage of dislocations in the fixed-income CEF space resulting from traders who assumed that a September taper was on deck for the Federal Reserve, despite continuing disappointing economic data.

And even if we turned out to be wrong on the first count, historical performance data has shown that management has proved adept at preserving capital while navigating a rising-rate environment.

Though we were correct on the first count, it remains to be seen to what extent the fixed-income market will adjust in response to the Fed deferring the curtailment of its quantitative-easing program until later. Certainly, the jump in rates resulting from speculation about the Fed’s next move has undermined the momentum of the housing market’s rebound. And that could mean economic data continue to disappoint.

In its recent fund commentary, management said they believe that rising rates will eventually reverse in light of underwhelming economic data, and that preferred stocks could, therefore, regain most of their lost ground. As a reminder, the fund invests in a mix of dividend stocks and preferred securities, which, as of July 31, comprised 36 percent and 61.3 percent of assets, respectively.

The fund’s net asset value (NAV) currently stands at $13.79, while the units trade near $12.04, a substantial discount of 12.7 percent. New money should only invest in CEFs when they trade at a discount to NAV. In this case, we want our buy target to be no higher than PDT’s long-term discount to NAV, which is about 4 percent. As such, we’re lowering our buy target to 13.24.

Memorial Production Partners (NSDQ: MEMP) reported second-quarter distributable cash flow (DCF) of $24.6 million, an increase of 32.3 percent sequentially and 68.5 percent from a year ago. Its distribution coverage ratio improved to 1.07 from 0.82 last quarter.

The master limited partnership’s (MLP) average daily production of 115.1 million cubic feet equivalent (MMcfe) was an increase of 23.9 percent from the first quarter and 32 percent from a year ago.

Crude oil accounted for 41 percent of revenue, while natural gas and natural gas liquids (NGL) accounted for 39 percent and 20 percent of revenue, respectively. The average sales price per Mcfe jumped 12.7 percent from a year ago, to $5.50, due entirely to the 48 percent increase in natural gas prices since then.

Management has diligently hedged the MLP’s exposure to commodities: Natural gas production is 87 percent hedged for 2013 and about 79 percent hedged through 2014-15, while crude oil production is 83 percent hedged for 2013 and 73 percent hedged through 2014-15.

Thanks in part to acquisitions, management’s guidance for full-year 2013 also improved. Distributable cash flow is projected to range from $129 million to $133 million, up from a previous forecast of $92 million to $96 million. And the distribution coverage ratio is expected to improve to a range of 1.1 to 1.2 versus the prior forecasted range of 1.0 to 1.1.

More recently, on Sept. 11, the MLP announced it had completed two separate deals to buy oil and natural gas assets in East Texas and the Rockies for $29 million. The acquired properties totaled 237 gross (61 net) wells.

Altogether, MEMP has secured 21.3 billion cubic feet equivalent of proved reserves. The MLP tapped its $1 billion credit revolver to fund these two transactions, which are expected to be immediately accretive to distributable cash flow.

Among Wall Street analysts, the mix of sentiment now stands at six “buys” and three “holds.” In light of strong unit-price appreciation as well as higher projected DCF, Memorial Production Partners is now a buy below 20.50.

On Sept. 9, Natural Resource Partners LP (NYSE: NRP) announced that it plans to conduct a private offering of $300 million in 9.125 percent senior notes that will mature in 2021.

NRP plans to use the net proceeds from this offering to pay outstanding borrowings under its credit facility. The master limited partnership will also apply a portion of the proceeds toward paying off some of the $200 million it borrowed to help finance its acquisition of OCI Wyoming in January. Natural Resource Partners remains a buy below 22.

PennantPark Investment Corp (NSDQ: PNNT) posted net investment income (NII) per share of $0.27 for the second quarter, which came much closer to covering its $0.28 per share quarterly distribution than last quarter’s results. Management reiterated its comfort with temporarily under-earning its distribution, while they remain ultra-selective with pursuing new additions to the portfolio.

As a reminder, this careful attention to underwriting each financing is what enabled this business development company (BDC) to successfully navigate the Great Recession, despite the fact that it went public a little more than a year before the financial markets began unraveling. In fact, this BDC actually boosted its distribution during the downturn, and it’s only had seven loans out of the 270 financings it’s completed thus far go into nonaccrual.

Management said they continue to focus on defensive companies with low leverage that generate high free cash flows with whom they can arrange loans that have strong covenants and high returns. At quarter-end, the BDC had roughly $400 million in liquidity to take advantage of such opportunities, including about $300 million from its bank credit facility, $75 million from its second borrowing under the Small Business Administration’s Small Business Investment Company (SBIC) program, and $16 million in cash.

It’s pretty normal for BDCs to not fully cover their distributions for a period of time. But as we stated in our initial recommendation of this security back in May, we’ll continue to monitor the coverage trend, and if PennantPark falls short for four or more quarters, then we’ll consider selling it. Still, it was heartening to see the BDC’s NII per share improve a full $0.06 per share from last quarter.

We’ll also continue to monitor how the BDC space performs in light of eventual Federal Reserve tightening. While we turned out to be right that the Fed’s widely anticipated taper would not occur in September, we believe this action has merely been deferred. The central bank will eventually curtail its easing, and the financial markets will adjust accordingly.

And given the sudden spike in rates that accompanied Fed Chief Ben Bernanke’s earlier statements about the Fed’s intent, it’s too much to assume that this adjustment will happen in an orderly manner. BDCs make their money by borrowing at low rates, while lending at what are often double-digit rates, so a shift in monetary policy will naturally affect their operating environment.

To that end, management observed that there was a tightening in the leveraged-loan space in June, but that it’s since bounced back, with middle-market demand for financing still exceeding supply. That means dealflow remains ample, which along with PennantPark’s extensive network should allow the BDC to continue its careful approach to new deals.

During the quarter, the BDC invested $73.3 million in five companies, including two with which it already has loans on its books. The details of these deals, as well as the existing portfolio show a modest improvement with risk in terms of yield and debt seniority.

The average yield on these new investments was 12.9 percent, which was down six-tenths of a percentage point from last quarter’s financings. Though management’s expertise and results have earned our trust, it’s still reassuring to see that they won’t stretch as high for yield as many of their peers.

The mix of debt in PennantPark’s portfolio also improved, with a greater percentage of loans higher in companies’ capital structures. Senior secured loans now comprise 30 percent of the portfolio, up from 26 percent last quarter, while subordinated debt decreased 3 percentage points to 36 percent of the portfolio.

A significant portion of quarterly activity was driven by early repayments of loans and their associated penalties. Of PennantPark’s $0.27 per share in NII, $0.21 was earned from recurring income from financings, while $0.06, which the BDC classifies as “other income,” was derived from debt-repayment penalties. Two portfolio companies were acquired, while two others opted to refinance their loans with bank credit.

Given that these loans are typically issued at high rates, it’s not unusual for companies to repay them early if they’re able to secure more advantageous financing. Management notes that the income from repayment penalties will generally range from $0.01 per share to $0.06 per share each quarter.

The $73.3 million in new investments was more than offset by the $117.8 million in repayments. As such, the size of the portfolio shrunk to $1.07 billion from $1.15 billion last quarter. That also translates into a slightly lower net asset value (NAV) per share of $10.43 versus $10.50 in the prior quarter.

The mix of Wall Street analyst sentiment currently stands at eight “buys” and six “holds.” Our long-term goal for this investment is for modest unit-price appreciation coupled with a consistent, high-yielding payout. Our buy target remains at $11.50 per unit, but patient investors should consider setting stingy limits closer to the NAV.

Spyglass Resources Corp (TSX: SGL, OTC: SGLRF) has put its light-oil-producing assets in Saskatchewan up for sale. The company plans to divest CAD25 million in assets in 2013 and another CAD25 million in 2014 in order to pay down debt. Management’s goal is to reduce the company’s debt-to-cash flow ratio to less than 2 from the current ratio of about 3.

On Sept. 13, management confirmed its monthly payout of CAD0.0225 per share, payable to shareholders of record on Sept. 27. CEO Tom Buchanan stated that although the company has no plans to increase its dividend over the next year, there are no concerns about cutting it. Spyglass remains a buy below USD2.25.

In late August, Windstream Corp (NYSE: WIN) completed a private offering of $500 million in 7.75 percent senior unsecured notes due 2021. The company will use the proceeds to refinance its $500 million in senior notes due 2019.

Windstream has completed its conversion to a holding-company structure and now trades on the Nasdaq under the same ticker symbol that it used when it was listed on the NYSE. The change will not have any impact on investors, but should facilitate the integration of future acquisitions. Windstream remains a buy below 11.