Encompass Fund Likes Teva, Gold Miners and Rare Earth Elements

by: Benjamin Shepherd

Although you should be leery of stock tips overheard at a cocktail party, there’s value to information gathered from a long-standing network of research analysts and industry contacts. Marshall Berol and Malcolm Gissen, co-managers of Encompass (ENCPX), aren’t afraid to apply a little elbow grease to the tips they glean from industry experts. The duo thoroughly vets these recommendations and will continue to add to positions, provided their investment theses remain intact. This strategy propelled Encompass to the top of Morningstar’s World Stock category in 2009. Berol and Gissen spoke with us about their market outlook and favorite sectors.

What’s your read on the US economy?

Gissen: The recovery has been much slower than most people anticipated, including us. There are many uncertainties hanging over the market right now: the election, income and estate tax policies, and whether the Republicans will gain control of Congress. The mortgage foreclosure issue still hasn’t been resolved, and the housing situation doesn’t look attractive, particularly until we see an improvement in unemployment. On the other hand, corporations are reporting decent earnings and sitting on enormous amounts of cash, though they’re reluctant to hire. We expect this to change gradually.

We look to add exposure to the superior growth prospects offered by emerging economies by focusing on companies that provide resources and consumer products to those markets.

China is an obvious example of a market we like. We think India and Brazil will do well over the next several years, and Turkey is attractive. There are concerns about the Chinese real estate market and that GDP growth may fall from 10 percent to 8 percent. That’s still very substantial growth, mostly because China has a very large population. India’s the same sort of story.

Berol: There’s no question that it’s a global economy and investment world these days. We look worldwide for companies that will fare well even in a slow economy. We’re invested in companies doing oil and gas exploration and production in South America. We hold mining companies operating in South Africa, South America, the U.S., Canada, Mongolia and China.

Your portfolio is extremely heavy on gold miners. What’s your outlook for the sector?

Gissen: The price of gold should head higher, though it’s difficult to say exactly when gold will hit $1,500 an ounce. A variety of factors contribute to this trend: The economy, inflation worries, terrible municipal and federal debts, and the possibility of wars and terrorist attacks. These threats help boost the price of gold.

And the easy gold has already been mined. Marshall and I have toured South American properties that contain enormous amounts of gold, so a handful of bonanza properties are left. But we’ve talked to a lot of mining executives who tell us how difficult it is to find and extract gold, so we think there will continue to be a lot of mergers and acquisitions in the sector.

All of this suggests that gold prices will probably rise; we want to have significant exposure to gold.

Berol: The price of gold should continue to rise, leading to questions about whether there’s a bubble. We don’t think so. Gold prices haven’t gone parabolic. Sure, it’s gone up over the last 10 years, from around $275 to $1,250. But gold has suffered corrections and consolidation along the way, and if you look at a chart, it’s risen on a reasonably steady basis over that ten-year period.

A bubble occurs when everybody regards gold exposure as a must-have, but many investors still dismiss gold’s future. On any given day, the media will say that gold prices rose or fell because of the dollar or profit taking, but the role of supply and demand is not as well recognized as it should be. It is far more difficult, expensive and time consuming to find gold or any other commodity these days. And environmental and social concerns mean that extraction takes longer and is more costly.

Why do health care names figure so prominently in your portfolio?

Berol: The health care industry benefits from extremely favorable demographics. The population’s getting older, there’s more and better health care available, there are new drugs and procedures, and life expectancies are improving. These factors drive the need for health care.

We like Teva Pharmaceutical Industries (NSDQ: TEVA), an Israeli company that manufactures and distributes generic drugs and a small portfolio of branded drugs worldwide. Teva is an outstanding company that has grown both organically and by acquisition and operates in a fundamentally strong industry.

We also own Delcath Systems (NSDQ: DCTH), a drug delivery company working on a process for delivering chemotherapy drugs to a particular organ through profusion. This method delivers the drug in a more concentrated form but limits side effects. The product is currently in Phase III clinical trials, and we anticipate that the Food and Drug Administration and the EU will approve the treatment. We’re looking to add to our position.

Did the US health care reform scare you off from investing in the sector?

Gissen: The companies we’re looking at have enormous potential, and the products they bring to the market are so necessary that we believe they should do extraordinarily well. Generic drugs should see greater utilization, which will be extremely favorable for the firm.

In the case of Delcath, one other crucial point is that the drug delivery system is believed to be effective with most organs and cancers. The process also prevents chemotherapy drugs from getting into the patient’s blood, thereby lessening damage and side effects. The potential market for Delcath’s product is enormous. Management is highly motivated to succeed and seems to be on the right path.

Why does so much of your research focus on rare earth elements?

Gissen: Many new applications for rare earth elements (REE) continue to be found, and these compounds feature prominently in green technologies. Hybrid cars use more than 20 pounds of REEs, and they’re also used in windmill and solar installations. They’re used in LED lighting, rechargeable batteries and many consumer electronics as well.

Until recently, approximately 95 percent of the world’s REEs came from China. The price of these elements has increased because the Chinese announced export reductions and cracked down on a number of illegal mines.

We realized several years ago that demand for REEs would increase significantly and invested in Avalon Rare Metals (OTC: AVARF.PK), a Canadian company that has a world-class resource in the Northwest Territories at Thor Lake. Management expects the play to enter production over the next several years.

The company has solid financials and little debt. It’s an attractive bet.

Berol: We came across the rare earth elements several years ago. We come across a lot of these investments through conversations with the management teams at many companies, as well as a number of research analysts and other contacts.

We do an awful lot of reading and talk to a lot of people. Malcolm and I co-manage the fund, but we also have two analysts who work with us on the fund and our private accounts. When an interesting idea comes to us, we follow up on it because we’re inquisitive about global trends and how they’ll affect the investment world.

We saw that demand for and the use of REEs was growing and sought companies that would benefit from that growth.

Dacha Capital (OTC: DCHAF.PK) is another company we invested in to leverage rare earth metals. Dacha formed earlier this year and has purchased rare earth elements in China. The firm exports them under license and stores them outside of China in anticipation that prices will rise over the coming years.

The company should profit from its inventory of these metals. The stock offers a way to play rare earth elements without being directly involved in their mining.

What’s your best piece of advice for the next year?

Gissen: I would be very cautious about the economy. There’s a lot of information available and tremendous efforts being made by sales teams to attract people to hot investment vehicles.

Berol: Beware of the drive to fixed-income investments. Don’t give up on equities. The statistics show heavy flows away from equities and into fixed-income mutual funds. That’s likely to prove disadvantageous over the next several years. Interest rates are at extremely low levels, depending what you’re looking at they could be at all-time low levels. There’s only way for them to go: up. There are no ifs, ands or buts about that. When rates go up, bond prices will fall, fixed-income funds will drop in value, and total returns may be extremely disappointing.

Disclosure: No positions