Warren Isabelle is a Managing Member of Ironwood Investment Management LLC, located in Boston. Ironwood is a prominent small-cap investor, defining small-cap as below $2.5 billion in market cap. Prior to forming Ironwood in 1997, Warren was Head of Domestic Equities for Pioneer Capital Growth Fund, Pioneer Small Company Fund and several institutional portfolios. Before joining Pioneer in 1984 he was an analyst with Hartford Insurance Company. He is a bit of a polymath, with a U Mass BS in Chemistry, an MS in Polymer Science and Engineering, and an MBA from Wharton. He has been the subject of articles in Barron's, Business Week, Forbes, Fortune and The Wall Street Journal.
I first met Warren at Pioneer in the early 1990s, and had the pleasure of talking to him late last week about his outlook for the year ahead.
JA: What are your predictions for 2013 overall, and what kind of market do you think we will be seeing?
WI: This year my crystal ball is as murky as I have ever known it to be. The crosswinds that are blowing are not gentle breezes; they are pretty stiff gale winds. I think we will see some growth spurts in the market this year, and some retreats, but frankly I don't see a heck of a lot of progress being made this year for the overall market.
Businesses have been on a roll the last four or five years in terms of improving productivity, cutting expenses, improving margins, and so forth. A lot of companies are making money hand over fist, but until we get some macro issues sorted out, those crosswinds are going to make forward progress difficult.
2013 should be a stock picker's market. We will be looking for companies that can maneuver through the times ahead. The market will have a hard time breaking higher ground, but we are stock pickers and always have been, and if we can continue to do our job well, our investors will be rewarded. The world is so concerned with the macro issues; it pays dividends for us to pay attention to those. On the plus side, we do have easy money - the cost of capital just seems to get lower and lower and though the recovery does not seem all that well established, you might say that time tends to heal all wounds. There are green shoots here and there, and that will continue. Small caps generally do better in a developing recovery, and we expect that to continue.
On the other hand there are plenty of mines that could explode and cause big problems. As such, we have to be careful of stock trading liquidity. One thing that has benefited us at Ironwood over the last few years is that we have been much more willing and able to maneuver with individual holdings and as a result, our performance has not suffered from liquidity issues as it has in the past. Before that we used to be dedicated buy-and-hold investors, period. But since 2008 we believe we have reconsidered on that issue, and we are not afraid to hold cash now if the environment warrants.
JA: In many recoveries, there are a lot of new companies started by people who either were laid off in the downturn, or who lost faith in the ability of their employers to continue growth. Are you seeing any of that this time around?
WI: Here's my take. I do a lot of work with the University of Massachusetts, both on the investment side for the Foundation, and on the intellectual property side with the Lowell campus. I can tell you that the entrepreneurial spirit is as alive as it ever was. But what has happened is that the traditional venture capital model of relatively long-term funding with an eventual IPO - has been impacted negatively by this ugly downturn. As a result, many providers of early-stage capital have largely lost patience for long-term investments. The era of that model being dominant, I think, is over, and that VC model has run its course. The VC money that is being invested now, and there is less of it, appears to be being put into narrow areas like Software as a Service and Cloud Computing. The model is shifting, and I am sorry to say that I do not think that crowdfunding will be the answer.
There just are not a lot of IPOs. We don't see the new-company formation process in as high a gear as it was before. The risk-return equation is now much more weighted toward return, and light on risk. That means deals are later-stage, and valuations are higher. The early-stage companies are not in the mix. Is the model totally broken? All I can say is that later-stage deals are what we see happening now.
JA: Do you think we will get a budget this year?
WI: I think the House will produce a budget, and then it will be up to the Senate to modify it. There will be a good deal of hemming and hawing and a lot of finger pointing, but I think we will get there. A lot depends on whether President Obama will negotiate or not.
JA: Let's talk about sectors to watch for 2013.
WI: I can tell you what we're looking at. First of all we think that because of the general uncertainty about our economic situation, "discovery" names will be interesting this year. For example, there are many unmet needs in healthcare - therapeutics, diagnostics, and even medical devices to some extent. If we can continue to find the names that have potential, not only will that help in meeting medical need, but large pharmaceutical companies and the bigger and successful biotech companies will be standing in line seeking to replenish their product offerings. Those big companies have become distribution channels to a large extent, and they need the discovery companies to help in coming up with new products.
We tend to like companies that are local - not exclusively, but that is a bias we have. We like to be close to the companies we invest in, knowing what makes them tick, and close geographically if possible. If your investments are in the neighborhood, it's a lot easier to fill in the information blanks, it seems to me. One local healthcare company that we have owned for a while that is still relatively small is Synta Pharmaceuticals Corp (SNTA), which is in Lexington. One thing I noticed early on about them is that with new financings, the senior management consistently invested serious money into the future of the company. Their most recent offering was also heavily subscribed by insiders. We consider it very favorable when management is willing to take the same kind of risk that we are exposed to.
SNTA has a number of products, but I will mention its lead product, Ganetespib, an Hsp90 inhibitor. Hsp90 is a protein that is necessary to the growth of tumors, and if you can inhibit it, the theory is that you can degrade or destroy the tumor, the more so in combination with other cancer drugs. I believe it has shown pretty good results in non-small cell lung cancer, for instance, which is a notoriously difficult cancer with high mortality rates. And, as I said, the insiders have put their own money on the table, which is encouraging. SNTA has gone from $4 to $10 in the last year, but we think there could still be good upside if, with clinical success, some big pharmaceutical company decides to make a bid for them.
Another company, and one that took us a long time to get involved with, is Repligen Corp (RGEN), which is also close by, in Waltham. I visit them every few months to make sure I stay on top of developments there. About 18 months or so ago, they had change in their board of directors which turned out to be the first clue that the company was finally undergoing a transformation. Their legacy and main business currently is the supply of Protein A, which is essential to Protein A affinity chromatography, considered the gold standard in the purification of monoclonal antibodies. They went on to develop some drugs, but were never adequately structured for that, in my opinion, though over time they actually built up a pretty good cash balance. Following several disappointments and apparent lack of focus, they came dangerously close to being perceived as something of a zombie. Then the Board changed and they seemed to find direction and began to employ that cash. They acquired their only competitor in Protein A and are now in a dominant position, with opportunity to really ramp up profitability by rationalizing costs and capacity. In addition they have developed a line of disposable "column" products that are used in chromatography for the downstream purification of biologics. This new modular approach to development and production is rapidly gaining acceptance by their customers which now include CROs, discovery companies, successful biotechs and big pharmaceutical companies.
JA: Which other sectors are you watching closely?
WI: It so happens that through individual stock selection, we have increased our weighting in technology, and in particular we're watching some turnarounds with interesting new agendas that are gaining traction.
First, though, I'll mention Extreme Networks (EXTR), which is out in California. They make data switches, and theirs are the fastest and best products available in that category. Why is it a great investment now? We believe the need for ultra-high-speed data switches is here. What has held EXTR back in the past has been the higher cost of their industry-leading switches, and while we think their management was great on the tech side, they could have been better in marketing. Recently, a new management has come in and emphasized marketing and how to go to market. Extreme has great products, a good balance sheet with $100 million in cash such that with good execution, we believe the stock could be a multiple of what it is now.
A second one - and again a local company in Westford - is Sonus Networks (SONS). They are a comeback company who had an earlier gateway product that essentially became commoditized and is winding down now. That is all people see about SONS today. But they have a new product line now built around Session Border Controllers, or SBCs. They basically hold access (a "pipe") open for a user, something like a traffic cop, so lots of information can get through when desired. We think that the old product decline will be offset by the growth of the SBCs over the next 18 months or so, and we think that most people in the market are looking only at the old product. This company has a $600 million market cap with $320 million in cash. And the new CEO is taking all his compensation in equity. That's impressive, and we think there is at least a double in this stock.
JA: Fascinating. What's next?
WI: We like some agricultural companies as I cannot overstate the importance of food production given the global growth of what we would call the middle class. We are again looking favorably at Chiquita Brands International (CQB). It is not a sexy company, but they appear to be back on track. They went off the rails with pre-packaged salads, as the effort to boost margins and steady earnings never materialized. They were also hurt by a bizarre tariff structure introduced by the European Union which cut deeply into volumes and profits. Now they have new management and the emphasis is back on bananas and fruit. All I can say is that the rough edges are smoothing out; the tariff picture is much better; and spending is again going to their traditional business. In past years, at the peak of a cycle, they were earning $3 a share, and the stock approached $30. Now it's at $8, but we think they can earn $2 a share in the near future, and if that happens, the stock ought to be at least double from here. Yes, they have a lot of debt, but their cash flows have always been adequate.
We also like Pilgrim's Corp out in Colorado. Most people know them as Pilgrim's Pride, and they are a chicken and turkey company. They were bailed out a few years ago by JBS, a large Brazilian company that now owns 75% of the company which dampens investor interest, but we think that also provides downside protection. The stock had gone down to $3 on fears of rapidly rising feed costs, so we increased our position and the stock has rebounded nicely to over $7, with room to grow.
JA: I have to say those were not companies I was expecting you to mention. Anything else?
WI: We like natural gas, and I'll mention two companies: Rex Energy Corp (REXX) and Carrizo Oil & Gas (CRZO). They did not help us last year but we think they are good operators which is the key to the investment thesis. They are developing a lot of properties through fraccing and drilling, particularly in areas where gas liquids are significant part of the production. In the energy industry we are looking for companies that can acquire good properties and develop them efficiently. Natural gas is currently in abundant supply and pricing is depressed. Of course we would like to see pricing increase, but we are much more volume-oriented. Longer-term, we believe we will be seeing natural gas exported from the US, and prices will come up if only because the differential between natural gas and oil is too wide. All good for the stocks, I would suggest.
JA: That's a lot to consider, Warren. Many thanks.