Gnostic Capital Large Cap Global Account Return for the Quarter Ended 03/31/23.

The objective of the portfolio is to best all comparative indexes over a longer duration, not necessarily on a quarter to quarter basis.

In the first quarter of 2023, the Gnostic Capital account outperformed two of the three major US indexes as well as besting the representative global index.

For the fiscal quarter ended March 31st, 2023 The Dow Jones Industrial Average increased by .4%. The S&P 500 increased by 7% and the NASDAQ Composite Index grew by 16.8%. The MSCI world index appreciated by 7.3%.

In comparison, the Gnostic Global Portfolio started out the fiscal year with a value of $677.31 USD and closed out the quarter with a value of $730.34 USD, a return of 7.8%.

The first quarter’s rebound in the NASDAQ index, based upon the horrific losses of 2022, is not particularly interesting for me. I liken it more to beachcombing. Sometimes, one loses their waterproof wallet, full of money and ID, while body surfing. Searching in vain, for hours up and down the beach, turns up, not the wallet, but rather, a souvenir shark-tooth bracelet lost by another swimmer; possibly it is a nice find, but not nearly as valuable as the contents of the wallet.

That was Q1 for the NASDAQ, investors sorted through the rubble, on the heels of a 33.1% + index loss in 2022, reducing their 15 month loss by about 1/3, yet are, incredulously, declaring a win. As the NASDAQ index requires a further increase of 27.9% just to break even on the 2021 year end value, before taking into account the time value of money, I remain unimpressed.

It was recently asked:

“why, given the fact that the Gnostic Portfolio invests globally, unrestricted by region, is a basket of major US indexes selected for comparative reference rather than against a pure global index”?

The answer is straightforward. Global indexes have generally underperformed US major composite indexes by such a significant margin, for such a long time, and with such persistence, that they are unrepresentative of global investing at its best. The returns earned on large cap global indexes are too low a bar to be of interest to me and as a basis for comparison, the application makes the Gnostic Portfolio returns look absurdly high in comparison. It has always been the policy of this portfolio to seek out challenging objectives for comparison. The MSCI global index, arguably the most appropriate global index, and, if nothing else, the best known, since January 1st, 2010 has grown from an index value of 1119 to 2791. This represents a compounded annual return of roughly 7.1% over the 13.25 year timeframe.

Marketers pummel us with advertising, pushing a narrative that global diversification is always better than investing in US based companies, which is false and the index comparisons confirm that.

In comparison to the MSCI World Index, an equivalent investment in the S&P 500 index has produced a compounded annual return of 10%. The same capital placed into the DJIA has compounded at 9.1% per annum over the equivalent timeframe. The NASDAQ composite index has generated a total compounded annual return of 13.3% over the past 13.25 years.

The relatively limited return of global investments, in the light of US equity index absolute and relative outperformance, then brings forth a highly appropriate follow-up question. “As global equity investment, by and large, results in demonstrably worse results than pure US equity investment, why bother to seek out foreign investments at all?”

Why, indeed? There are two reasons. The first part of the reply is: “wider choice”. Without a doubt, the US economy remains the best and most diverse economy on the planet. Financial reporting by US companies, for all the grousing I do, remains heads and tails above the disclosures in other developed nations throughout much of the world. British companies feature incredibly poor detail, many European companies fiscal reports are sufficiently obtuse that one wonders why they take the time to supply any data at all. In short, US reporting might be generally poor, but it is the best we’ve got. Furthermore, the US economy remains a largely freely capitalist economy in comparison to most of Europe, most of Asia, South America and Canada.

To completely disregard the remainder of the world and to limit one’s selection to only US domiciled securities perpetuates a bias that EVERY American company is better than every other company outside of the United States, that EVERY American balance sheet is superior to those outside of America. In terms of indexes, that conclusion is likely true, but for active investors, limiting choice is nothing more than a profit minimizing constraint. To be of the mindset that US domiciled investments are, for the most part, superior to what is out there throughout the remainder of the planet is true; to conclude that there are NO exceptional companies outside of the United States is false.

The second part of the answer is a US-only investment criteria eliminates industry specific opportunities that are not yet publicly available via direct American exposure. Several countries have privatized economic subsectors which remain, for now, in US state and federal control. Specifically, I speak of airports and seaports. Many nations throughout the world have privatized these businesses for the benefit of individual investors. Most airports and seaports are terrible money-pits, but a handful have been truly remarkable moneymakers.

I don’t invest globally based upon externally marketed campaigns that promote some narrative of foreign markets being not well correlated to US markets, thereby offering some sort of hedge against US volatility; again, that is largely false as equities globally all move directionally for similar reasons, varying primarily only in degree based upon currency changes and/or local interest rates.

The Gnostic Portfolio operates with a principle, backed up by action, that the US remains the best place for capital, overall, on the planet. But, “best overall” does not equal “exclusively best” and that is why the account sets hurdles against the toughest set of benchmarks available, while also looking outside of the United States when it is is feasible and profitable to do so.

Investment in non-US domiciled equities was key to absolute and relative outperformance in Q1.

Where the Gnostic Portfolio prevailed over the most representative indexes in Q1 was entirely due to appreciation by 4 securities, all of them foreign.

1. Grupo Aeroportuario Del Sureste appreciated by 31.5% in Q1.
2. Grupo Aeroportuario Del Pacifico appreciated by 35.7% in Q1.
3. Grupo Chedraui appreciated by 34.7% in Q1.
4. Novo Nordisk improved by 17.6% in Q1.

Differing from the typical NASDAQ equity, which had their throats slit in 2022, only to experience a moderate rebound in the first quarter of 2023, these four companies all experienced fine absolute appreciation during 2022, with Q1 representing a continuation of that trend. It was the ownership of these 4 securities that accounted for the difference in return of the model portfolio to that of the DJIA, the S&P 500 or the MSCI world index.

And this is why I invest globally, carefully, in a few, non-US based equities, to either obtain exposure to an industry that is absent from the US publicly traded economy, or I choose a foreign equity if my analysis determines it to be superior to the best US company in the same field. More sector choices, more investment choice, but not diversification simply for the sake of it.

There were several pieces of business news reported by companies held in the portfolio, some positive, some negative.

Turning to the positive.

1. Canadian Pacific Railway Ltd (CP-NYSE, $76.94) was cleared by the STB (Surface Transport Board) in the US to complete the corporate consolidation of Kansas City Southern Railways in Q1. CP had purchased all of the equity of KSU in 2022, but was unable to fully combine and consolidate the operations until a critical US clearance was granted. With the approvals finally having been made, the two companies will be able to combine income statements, balance sheets and start to rationalize operational budgets for the coming quarter. This will remove a minor element of confusion for shareholders and analysts.

2. Novo Nordisk (NVO-NYSE, $159.14) has announced positive phase 3 trials of an increased strength oral pill to be marketed for weight loss. This oral version of the GLP-1 Ozempic will be either a 25 mg to a 50 mg formulation, essentially a 2X-4X strength version of Rybelsus. Test results, conducted over a 68 month period of time and featuring a representative sample of subjects, indicates almost a 10% reduction in body weight per subject and did so with patient side effects largely in-line with the injectable formulation. The active pharmaceutical ingredient in the GLP-1 pill must be significantly greater than an injectable as much of the product is destroyed by stomach acid. However, enough is absorbed in this formulated strength to do the job and keep gastrointestinal issues in-line with the injectable formulation, all formulations of GLP-1 offered by Novo-Nordisk are so hotly selling that they are often back-ordered.

Novo-Nordisk has not produced a breakthrough, but rather, added a brand extension of the GLP-1 franchise. This pill will, for many weight loss customers, represent either an alternative to the needle based medication, or, a product to be used as a weight maintenance medication once faster weight drops have resulted from use of the injectable for some time.

It is likely that approval of oral Ozempic, which I feel is largely a formality at this point, will resolve an issue for analysts in modeling. The nagging question for most was: “what will GLP-1 sales be at Novo-Nordisk once patients have reached their target weight goal using Ozempic/Wegovy?” Approval of another oral medication will stabilize ongoing revenue, will greatly increase the pool of potential customers as there are more persons willing to swallow a pill than inject medication via needle and will also reduce the cost of production. Pills can be stamped out very cost effectively whereas injectables represent a far more expensive and time-consuming manufacturing and filling process. A GLP-1 oral medication for weight loss will likely be super profitable and accretive for the business model.

There has been a great deal of public grousing about the lack of supply for Ozempic and Wegovy.

What investors, diabetics and weight loss consumers haven’t thought through is why Novo Nordisk has been slow to roll out the supply to insured patients, thinking it to be some sort of executive planning failure. In fact, the product is NOT scarce, provided that a consumer is willing to pay the current market price for the medication with that market price determined to be >0 or >co-pay deductible. For those willing to purchase the medications out of pocket, at a rate above zero, supply is largely unlimited. In summary, selling $11 billion + in GLP medications for 2022 is hardly a failure in the pharmaceutical world; those willing to pay directly for their medications have absolutely no issues in obtaining supply.

Alternatively, it could be posited that Novo Nordisk has learned from a previous pharmaceutical rollout of Victoza, a highly regarded diabetic drug deemed superior to a competing product sold by Eli Lilly, but that never did gain the traction required to be #1 in its category. The problem is one of gatekeepers; Eli Lilly has an industry reputation for a corporate culture of employing absolutely ruthless and extremely pushy sales reps with deep inroads in physician offices and pharmacy benefit manager formularies, barriers that proved impossible for Novo-Nordisk to overcome. In big pharma, the best product doesn’t always win the day.

So, Novo Nordisk opted to market Ozempic and Wegovy a different way; they rolled out the product and directed abundant supply primarily to social influencers, who created such a positive buzz that diabetics, who tend to be somewhat skeptical (hard to sell to) and brand loyal (hard to get to switch medications), who purchase most of their medication through insurance co-pay programs; that public is now completely worked up about NOT being able to access Ozempic/Wegovy as they wish. Were the product to be free of charge, most diabetics and weight-loss patients likely wouldn’t even want it and doctors would have to educate patients, which requires time and energy, both in very finite supply at a physicians’ office.

Marketing using influencers instead of going through doctors has overcome two hurdles:

1. It bypasses the Eli Lilly gatekeeping reps from running down Ozempic/Wegovy. The demand is a tidal wave, with each and every diabetic and each lifestyle patient wanting to lose weight now experiencing a sort of pharmaceutical FOMO (fear of missing out), begging and pleading for the Novo GLP-1 formulations. Doctors, PBMs and Eli Lilly reps, having lost control of the narrative, have virtually no say in the matter at this point.

2. Novo does not have to get their reps in front of physicians to promote the product, nor do they have to educate the public about Ozempic/Wegovy. Social influencers have legitimized the brand and have very effectively done the job on behalf of Novo-Nordisk. This places additional pressure upon the various PBM to include all or more of the products in their coverage formulary, or else potentially to lose HMO business to a competing health insurer.

Social influencer marketing of the product has proved to be so successful that Ozempic/Wegovy has become entrenched in the mind of the diabetics and public seeking to lose weight, even before supply has become available to them. It is not a failing, rather, it is an absolute stroke of genius. Wegovy is presently annualizing at a $2 billion run rate, and that is without widespread acceptance in PBM formulary; most patients on Wegovy are paying for the medication directly out of pocket. This is one of the few products in the pharmaceutical world that can presently be classified as a “positional good“.

A negative consequence of the faster than anticipated uptake in Ozempic/Wegovy will likely be felt by the alcoholic beverage industry.

Use of GLP-1 medications greatly inhibit cravings for alcohol, to the point that Novo-Nordisk is presently running a phase 3 trial of Ozempic as an alcohol cessation aid for those who suffer from alcohol dependency. In North America and the developed world, the GLP-1 class of medications has experienced explosive growth thus far and that should continue for some time. In the event that GLP-1 products are ultimately approved for sale to battle chronic alcoholism, that will have an impact upon low end brand alcohol sales.

But, for now, the high end sales will likely be impacted as social media influencers, Hollywood/Bollywood types and other the well-heeled user of Ozempics/Wegovy report that they have completely lost their craving for alcoholic beverages, even at the social setting level. Those persons don’t consume “two-buck Chuck” or bar-pour house brands; no, they purchase the $100 bottles of vodka, the ultra-high end tequilas, the uber-expensive scotch, the heavily marketed gins and that is where the alcoholic industry has shifted production and marketing dollars towards.

High priced beverage purveyors might well be on the verge of stagnation, all due to the steady and inexorable rollout of a highly effective weight loss injection/pill that just so happens to curb or eliminate one’s desire for an alcoholic drink. GLP-1 products sold by Novo-Nordisk collectively surpassed $11 billion + in 2022 and could, at forecast rates, be annualizing above $25 billion US by the end of 2023.

A growing number of physicians are already prescribing Ozempic, off-label, as an alcohol cessation aid, reportedly with spectacular effect. It should be a largely foregone conclusion, given the demographic breakdown of the lifestyle weight loss patient, there WILL be an appreciable impact upon high-end alcohol volumes in the future. Maybe it starts this year.

Now, to the negative.

The Cigna Group and UnitedHealth Group have experienced not one, not two, but three negative developments that were declared within the first fiscal quarter.

1. The US government has determined that Medicare/Medicaid reimbursement rates will be reduced in the 2024 fiscal year as compared to the 2022-2023 reimbursements. The final rate case was determined on March 30th and at a net rate increase of 3.2%, under the optimal scenario, is below the current rate of inflation. This suggests that profitability of the government payor plans will be moderately to sharply reduced in 2024.

The financial impact could be quite material for UnitedHealth which has a very large book of business wholly reliant government reimbursement. It will be of far lesser importance to Cigna, who generates a much smaller percentage of the HMO business from public payers. For both companies, the financial impacts will be felt in 2024, not for this fiscal year.

2. the “PBM Transparency” bill, now working its way through the US legislative branches, will remove several categories of profit from pharmacy benefit managers, the massive drug wholesalers/middlemen. Cigna owns and operates Express Scripts, one of the largest PBM in America. UnitedHealth Group also operates a massive PBM but much of that business is internalized.

3. The state of Ohio has accused Cigna and several other pharmacy benefit managers of price-fixing. Personally, it is my view that the case has merit; that coordination between various PBM has likely been ongoing for some time. I had noted as much in my annual summary, stating that health maintenance organizations, through their greatly enhanced levels of profits over time, have more likely than not been operating in something less than a freely competitive marketplace. That said, collusion is easy to level against a corporation, but not always easy to prove.

As a result of the two pending changes for government payor reimbursement rates in 2024 and the pricing reductions that will take place assuming the PBM bill is passed as proposed, CI will see an aspect of future growth removed from its PBM business as well as an actual reduction in revenue from the Medicare/Medicaid book of business for 2024. Should the price-fixing case have legs, it is likely that Cigna will choose to settle for a large fine and get on with their business, but it is far too soon to assess any outcome. UnitedHealth will likely experience a relatively modest reduction in growth at its internalized PBM division, but should report a genuine reduction in profit to be earned at the sizeable government payor business for 2024.

The share prices of both companies have declined fairly hard in Q1, with UNH down by close to 12.2% and CI down by 29.6%. These declines suggest that the earnings impairment from the legislative and payor reimbursement changes will have a greater far impact on Cigna than UnitedHealth. That seems fair, considering the disproportionate size of the PBM business at CI; Cigna is primarily a very large PBM mislabeled as a health insurance company.

Whether or not the share price reductions of the two companies now capture the negative developments is above my pay grade. I do NOT intend to make any changes to either position, given the impermanence of federal funding models. With government reimbursement in health care, what is typically taken away in one fiscal year occasionally gets replaced in a subsequent year. Furthermore, the integrated business model of an HMO is designed to be very difficult for regulators to fully cost out: opportunities exist at most health insurance companies to overcome funding reductions in one division through the shifting of fees through another department. Nor will I add to either position on these declines; my policy is typically not to average down when a fundamental, negative, change in the business model is possible.

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