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Building a Hedged Portfolio Around an NVO Position

Summary

One of the more appealing stocks to consider as part of a concentrated portfolio is Novo Nordisk, the leading diabetes care and biopharmaceutical company.

We review some reasons why Novo Nordisk is appealing, and discuss how an investor can include it in a concentrated portfolio, while limiting his risk and maximizing expected return.

We recap the method, show how you can build a concentrated hedged portfolio yourself, and present a sample hedged portfolio built around Novo Nordisk.

The sample portfolio is designed for someone with $80,000 to invest, who wants to limit his risk to a drawdown of no more than 18%.

The sample portfolio has a negative hedging cost.

The Number One Stock In the World

Part of the attraction of Seeking Alpha articles is often the comments they generate. In the latest installment of his series on his top investments ("The #1 Stock In the World, Part II"), hedge fund manager and Seeking Alpha contributor Chris DeMuth, Jr. named Ocean Shore (OCSH) as his current favorite. In a comment on that article, his fellow Seeking Alpha contributor Harm Elderman offered an intriguing alternative selection for that title, Novo Nordisk (NYSE:NVO), and added:

"It's been my largest share of my portfolio for over 8 years and every year it's been an incredible cash cow (as it has been all the years before and will be in the future). Seriously, take a look. This firm has bent some stock market rules (in my view) over the last 25 years in regards of risk/reward profile."

The Appeal of NVO

Although DeMuth aims to "sift the world", it's understandable that he can't cover every promising stock. At the same time, a closer look at NVO illuminates the appeal it has had for Elderman and many other investors.

Riding a global mega trend

Although Novo Nordisk is active in other areas such as growth hormone treatments, it remains a leading manufacturer of diabetes medications, such as the NovoLog FlexPen prefilled insulin syringe, pictured above. Diabetes is a global epidemic: according to the World Health Organizaton, as of 2014, 9% of the world's adult population was estimated to suffer from the disease. The International Diabetes Foundation's Diabetes Atlas estimates the total number of diabetes cases globally is 387 million. By way of comparison, the WHO estimates there are 37 million patients in the world living with HIV. The scale of the diabetes epidemic, and Novo Nordisk's 90-year history in diabetes treatment, provides some context to the remarkable long-term chart of the company's shares:

Not only does the scale of diabetes dwarf that of HIV and AIDS (fewer than half of those infected with HIV currently suffer from AIDS), but the epidemic is expected to grow considerably over the next two decades. The Diabetes Atlas estimates 592 million people will be living with the disease in 2035.

Selected Fundamentals

Novo Nordisk shares aren't cheap on an absolute basis - according to Fidelity's data, the current PEG ratio for the stock (using 5-year earnings growth projections) is 1.97, while a PEG ratio of 2 or greater is often considered to be high. However, the average PEG ratio for the pharmaceutical industry is 4.13. Particularly striking, though, are the company's returns on sales, equity, assets, and investment, as shown below (image via Fidelity).

Equity Summary Score

Fidelity aggregates opinions on stocks from multiple research shops and weights each opinion by the historical accuracy of the researchers. It then consolidates that data into an "equity summary score", on a scale from 1 to 10, with 10 being the most bullish. As the image below shows, the current equity summary score for NVO is very bullish.

Given the appeal of NVO, why consider hedging it? For two reasons:

  1. Any stock may be subject to unpredictable, idiosyncratic risk. For a recent example, consider the emissions scandal at Volkswagen (OTCQX:VLKAY).
  2. All stocks are subject to market risk: in the event of a major market correction, all stocks are likely to plummet.

You could simply buy and hedge NVO, and we'll show a sample hedge for it below, but the benefits of the hedged portfolio method are that it can lower your overall hedging cost and let you maximize your expected return. So, we'll use NVO as starting point and show how you can build a hedged portfolio around it for an investor who is unwilling to risk a drawdown of more than 18%, and has $80,000 that he wants to invest. First, though, let's address the issue of risk tolerance, and how it affects potential return.

Risk Tolerance and Potential Return

All else equal, with a hedged...


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