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Inside This Issue

1 Introduction

2 Ongoing Recommendations

3 Updates on Discretionary

Stock Picks

6 Analysis of Seth Klarman’s

Historical 13F Filings

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Performance Update: Small-Cap Strategy

Executive Summary

• Our 15 stock micro-cap healthcare portfolio lost 20.9% between May 1st,2015 and October 11th, 2016 vs. a loss of 7.2% for SPDR S&P Biotech ETF(XBI) during the same period.

• We aren’t making any changes to our portfolio this month. We providedupdates about Baxter, Adamis Pharmaceuticals, Quotient Ltd, and NeosTherapeutics in this issue of the newsletter.

• In the last section of this issue we analyzed the performance of SethKlarman’s historical 13F portfolios. Klarman has an excellent reputation andhe holds a number of biotech positions in his equity portfolio. Our analysisshowed that his healthcare stock picks, on average, failed to generatepositive alpha and investors should pay attention to his non-healthcaremicro-cap stock picks to outperform the market.

Monthly Healthcare Newsletter September 2016 Issue: 40

Monthly Healthcare Newsletter2

Ongoing Recommendations

We officially launched our new micro-cap healthcare investment strategy on April 30th, 2015. This strategy willhave 10 ongoing picks that are updated quarterly. You won’t see any changes to these picks until November15th. This is a purely quantitative strategy that picks micro-cap healthcare stocks based on the overall activityof ALL hedge funds we are tracking.

The second component of our overall healthcare strategy is based on hedge funds’ – especially Sio Capital’s -portfolio moves, discussions in investor letters, and comments in investor videos and other interviews. Theseare discretionary picks that are determined by our team. Our research director, Dr. Ian Dogan, decides whichof Michael Castor’s and other hedge fund managers’ picks to include and exclude from our list. Currently wehave 5 stocks in this list. We aren’t going to make any changes to this list this month.

Overall our 15 stock healthcare portfolio lost 20.9% between May 1st 2015 and October 11th, 2016 vs. a loss of7.2% for the SPDR S&P Biotech ETF (XBI). We believe our stock picks are fundamentally better than the rest ofthe biotech universe. However, they aren’t immune to market declines. Our goal is to outperform healthcareindices on average over a 3-year investment horizon. If you are concerned about volatility and declines inthese stocks, you should consider hedging your risk by shorting XBI.

Here are our ongoing recommendations:

Issue Who Recommended? Company Price When Rec'd Latest Price Still Recommended?

Nov-15 Larry Robbins Anthem Inc (ANTM) $132.06 $121.90 Yes

Aug-14 Michael Castor Adamis Pharma (ADMP) $4.02 $3.02 Yes

Feb-15 Michael Castor Quotient Limited (QTNT) $17.00 $7.59 Yes

Apr-15 Micro-cap Strategy ARIAD Pharmaceuticals (ARIA) $8.67 $13.65 Yes

Nov-15 Micro-cap Strategy Dynavax (DVAX) $24.07 $10.48 Yes

Nov-15 Dan Loeb Baxter International (BAX) $38.15 $47.01 Yes

Jan-16 Michael Castor Neos Therapeutics (NEOS) $10.17 $6.88 Yes

May-16 Micro-cap Strategy Adeptus Health (ADPT) $64.52 $40.06 Yes

May-16 Micro-cap Strategy Ophthotech Corporation (OPHT) $47.02 $42.39 Yes

Aug-16 Micro-cap Strategy Community Health Systems (CYH) $10.78 $10.25 Yes

Aug-16 Micro-cap Strategy NxStage Medical (NXTM) $24.45 $24.02 Yes

Aug-16 Micro-cap Strategy Pacira Pharmaceuticals (PCRX) $43.87 $34.53 Yes

Aug-16 Micro-cap Strategy Cynosure Inc (CYNO) $52.85 $50.96 Yes

Aug-16 Micro-cap Strategy Endologix Inc (ELGX) $11.64 $12.47 Yes

Aug-16 Micro-cap Strategy Dermira Inc (DERM) $31.29 $34.21 Yes


Updates On Discretionary Stock Picks

Dan Loeb’s $16 billion hedge fund returned about 7% this year. We recommendedBaxter almost a year ago based on Dan Loeb’s activist campaign. The stock’s pricewas $38.15 when we recommended it. It was one of our best performers over thelast 12 months, currently trading at $47. Loeb discussed BAX in his second quarterinvestor letter:

Our largest investment in the portfolio is Baxter, a global manufacturer and supplierof health care products. Since its inception last June, the position has generated anearly 20% IRR. Despite this meaningful move in performance, its current size isconsistent with our conviction about the company and its leadership and thepotential we see for meaningful upside from these levels.

Our active involvement in Baxter began last summer immediately following the July1st divestiture of its biopharmaceuticals business, Baxalta. We believed Baxter hadthe opportunity to materially improve margins and increase shareholder value.Shortly after the Baxalta split and after we built our stake, Baxter’s CEO BobParkinson stated his intention to retire and, by the fall of 2015, Baxter’s Board ofDirectors had agreed to add two new members – Third Point Partner Munib Islamand Boston Scientific CEO Michael Mahoney. Munib also joined the searchcommittee for a new CEO and in November 2015 the Board selected seasonedmedical device executive and former Covidien CEO Joe Almeida to be Baxter’s nextCEO effective on January 1, 2016.

Mr. Almeida immediately outlined a three‐part strategy to transform Baxter: 1)portfolio optimization; 2) enhanced operational excellence; and 3) disciplinedcapital allocation. These initiatives are designed to improve total shareholder returnand free cash flow generation over the long‐term. Mr. Almeida also promised toevaluate Baxter’s businesses and research programs and determine which elementsof the company’s extensive portfolio should remain and which should be discarded.

While still early, we – and seemingly other shareholders – are encouraged by theresults of Mr. Almeida’s execution of this strategic plan. In particular, we thinkthree specific examples demonstrate the upside still to be realized as the new CEOcontinues to pursue his plan:

Vivia Shutdown. In early June 2016, Baxter announced the termination of the Viviahome hemodialysis platform developed in collaboration with DEKA Research andDevelopment Corporation. This program had been in development since 2007. Mr.Almeida explained his decision making at a Goldman Sachs Health Care conferencelast month, saying “as a matter of fact, the NPV of the discounted cash flows for theprogram for the next ten years was negative. So this allows us to take the cash andredeploy”. We expect Mr. Almeida to continue to make sensible decisions likethese as he proceeds with his portfolio review.

Baxter International (BAX)

Price When Recommended:

$38.15 (November 2015)

Current Price: $47.01

Market Cap: $26 billion

Volume: $175 million/day



Updated Long‐Term Plans. At Baxter’s Analyst Day on May 9th, Mr. Almeidaprovided updated 2020 guidance including 1) 17‐18% operating margins vs 14%previously, 2) 24‐25% EBITDA margins vs 20% previously, 3) roughly $2.5B inoperating cash flow vs more than $2.0B previously, and 4) free cash flow of roughly$1.75B vs $1.1B previously. The improvement in free cash flow is more than triplethe 2016 guidance of $500M+ and implies a growth CAGR of over 35%. In addition,Mr. Almeida introduced a 2020 EPS goal of $2.75‐$3.00 per share, implying a2015‐2020 EPS CAGR of 15‐17%. The revised operating and EBITDA margin targetsare more in line with industry averages and, if met, would drive meaningfulunderlying earnings growth before consideration of additional capital allocation.

Baxalta Retained Stake. As part of the spinoff of Baxalta, Baxter retained about a20% stake in the company. At the time of the spin, Baxter’s stake was worth justover $4.1B. On January 11, 2016, Baxalta agreed to be acquired by Shire PLC in acash and stock transaction, giving Baxter shareholders an unexpected windfall.Ahead of the Shire transaction’s close on June 3rd, Baxter successfully completedthe monetization of the Baxalta stake by: 1) executing on two separate debtexchanges, reducing overall gross debt by $3.7B; 2) exchanging 13.4M shares ofBaxalta for 11.5M shares of Baxter, reducing fully diluted shares outstanding by2.1%; 3) contributing $700M of Baxalta stock to the Baxter US pension, perguidance. These steps allowed Baxter to recognize nearly $5.0B in value from itsBaxalta stake, or over 20%.

While most of the attention thus far has been on the strategic focus and long‐termmanagement targets, Baxter’s balance sheet opportunity deserves specificmention. At the Analyst Day, Baxter’s management clearly stated that 2020 EPSguidance excluded any benefit from leveraging the balance sheet. However, givenlong‐term guidance, we can broadly estimate the amount of capital available tomanagement:

- Following the successful management and divestiture of the Baxalta retainedstake, Baxter’s net leverage declined to 0.6x on net debt of $1.2B, per thedisclosure at the May 9th Analyst Day. Guidance implies that Baxter will generate~$4.5‐5.0B in free cash flow between 2017‐2020 (vs $1.2B of net debt currently)and ~$2.8‐2.9B in EBITDA by 2020.

- If Baxter sought to maintain a net leverage ratio of ~2.0x, the company could havenearly $9.0B of capital to deploy for business development and/or returning cash toshareholders; note that the leverage ratio excludes the benefit from any acquiredEBITDA. In the scenario where Baxter simply returns all cash to shareholdersthrough share repurchases and assuming Baxter achieves the midpoint of itslongterm operational guidance with no change to multiples, we estimate over$0.75 per share upside to Baxter’s 2020 EPS guidance. This would result in a2015‐2020 EPS CAGR of over 20%.

We continue to see meaningful upside in Baxter and multiple ways to win as Mr.Almeida executes on his strategic program.

Baxter International (BAX)


$38.15 (November 2015)


Market Cap: $26 billion

Volume: $175 million/day



Michael Castor’s hedge fund Sio Capital returned 2.5% in September and trimmed itsyear-to-date losses to 21.4%. Luckily, his top 3 ideas returned 12.8% since our Augustupdate. Michael Castor provided updates about Adamis (ADMP), Quotient (QTNT) andNeos Therapeutics (NEOS) in the last couple of weeks in an investor letter and aninvestor video.

1. Adamis Pharmaceuticals (ADMP): Adamis was up in part because of so much mediaattention toMylan’s drug EpiPen. Adamis has as their lead product a competitive device.It is not an exact generic. Adamis focuses on making devices a little bit better or a littlebit different. And I like their strategy. Adamis’ device is a little bit smaller than EpiPen. Itis a bit shorter in length. And for the most part people hope they will never have to usethese devices. So, with that, having one that’s a bit easier to carry around should makefor commercial appeal.

Adamis was the beneficiary of some of the negative attention for Mylan. Their producthopefully will be approved when it goes in front of FDA at the end of this year, lookingfor approval in the middle of 2017. I continue to like their inhaler products as well. Froma valuation stand point I remain very enthusiastic about this company.

2. Quotient Ltd (QTNT): Quotient has been a favorite name. This past month there wassome really meaningful news. It spurred some of the market gains we saw, but I thinkthe market really overlooks some of the significance of two pieces of news. One,manufacturing is up and running. They are making their devices which uses an incrediblycomplex manufacturing system. It’s really very important, very meaningful news. Andtwo, now that they are doing that, they have to check each of their tests. Remember,Quotient is developing a testing platform that will make sure people who need bloodtransfusions get blood that is optimally matched for them. That ultimately drives bettermedical care, lower costs, faster care. It’s all the things we want to see in innovationsthat are being brought by healthcare companies.

So, along with producing their test, they tested the first batch of surface markers thatare found on red blood cells. And they told us they are getting the accuracy they needthat is as good as what is commercially available. The current testing platforms test onlyabout 4 surface markers out of the more than 30. Quotient will ultimately test a multipleof what’s on the market.

So the first batch of testing is done. A second batch is under way and we will know theresults in October, followed by going into Red Cross in Europe and running a test thatthey will then use to submit for approval in Europe. These are the final stages forQuotient’s development and it is gratifying to see the company finally deliver on thesemilestones which are, in our view, really key drivers.

3. Neos Therapeutics (NEOS): Neos uses a novel technology to formulate drugs as oral-disintegrating tablets (ODTs). ODTs are well-suited for pediatric patients, as somechildren have trouble swallowing pills. Neos launched its first ADHD drug (branded asAdzenys XR ODT) in June. The launch has been slower than we expected. We think thisis due to insurance companies successfully limiting patient access to new therapies. Webelieve Adzenys is a useful product that should have commercial appeal. The ensuingmonths will be important for Neos to gain traction among physicians.

Quotient Ltd (QTNT)


$4.02 (August 2014)


Market Cap: $134 million

Volume: $800 thousand/day

Monthly Mini Newsletter6

Analysis of Seth Klarman’s Stock Picking Ability

Seth Klarman is one of the most successful hedge fund managers of all time. His fundmanaged about $27 billion at the beginning of this year. Baupost lost 5.7% last yearmostly due to the fund’s big bets on Cheniere Energy, Micron, and KeryxPharmaceuticals. Here is how the fund explained the poor performance in an investorletter:

“I believe it is best to think about our 2015 results in two parts: what we brought on ourselves and whatresulted from the environment in which we operated. In the first category, we made some mistakes. I willdescribe the two largest. Our loss on Micron resulted from the fact that we remained overly optimisticabout our long-term thesis after it should have become apparent that the company’s widening costdisadvantage compared to its largest competitor, Samsung Electronics, would result in lower thanexpected profit margins. It also should have been clearer to us that the company was more vulnerable tothe decline in PC DRAM pricing than we had believed. By the time we decided to sell nearly all of ourremaining position, the stock was lower – a frustrating coda to an otherwise tremendously successfulinvestment that achieved total lifetime profitability of over $900M.

In the case of Keryx, we purchased our initial position at an average price of $14.50 per share based onwhat turned out to be an overestimation of initial prescriptions for Auryxia, the company’s approved drugto control phosphorous levels in dialysis patients. While we remain confident in the long-term potential ofAuryxia, and, thereby, our investment in Keryx, the slower sales ramp through 2015 did have a modestlynegative impact on our estimate of intrinsic value. The market, however, took a much harsher view andpunished the stock, driving it down to almost 70% in less than three months from about $10 to almost $3a share. Although this certainly was not good news for our mark-to-market P&L, we believe it was asignificant overreaction, and we were able to take advantage of the opportunity by investing additionalcapital on a private basis at what we believe is an incredibly attractive valuation. This, of course, is a greatillustration of the fact that even in circumstances when we reduce our own expectations, price declinescan far exceed what we judge to be warranted.

With respect to the broader investing environment, the public markets of 2015 were difficult to navigate.Opportunities for significant gains were largely confined to a small number of broadly-loved (and loftily-valued) companies. Most portfolios without those names moved sideways, at best. Those with exposure tothe energy sector performed far worse. Performance in energy names was, obviously, driven by adramatic decline in commodity prices. Companies with direct commodity exposure, like Antero Resources,fell to levels that ascribed little or no worth to valuable non-producing acreage. Even Cheniere Energy,with limited exposure to oil and gas prices, was significantly penalized by this unforgiving market.”

Investors pay a lot of attention to Baupost’s stock picks because the value hedge fund had lost money inonly 3 years out of the last 22. In this section of our newsletter we will analyze Klarman’s 13F stock picksand determine whether it is a good idea to replicate at least a subset of Klarman’s stock picks. Klarmanalso had significant investments in small biotech companies in recent years. We will find out whetherKlarman was able to generate any alpha in this space.


Our dataset covers the 1999-2012 period. Initially we will take a look at theperformance of Klarman’s entire 13F portfolio. The first table sums up the performanceof stock positions using the same weights that are disclosed in 13F filings. The secondtable displays equal weighted returns.

One interesting finding of our analysis is that imitating Klarman’s 13F portfolio would have generated superiorreturns between 1999 and 2012. However, his large-cap stock picks didn’t perform well at all. Returns werealso higher when we use equal weights instead of the weights assigned by Klarman. Klarman’s small and mid-cap stocks also performed extremely well until 2008, but his edge seems to have disappeared in recent years.

Overall, an equal weighted portfolio of Klarman’s micro-cap stock picks would have returned more than 20%annually between 1999 and 2012, and generated an annual alpha of more than 12 percentage points.


Baupost S&P 500 TR Four Factor Alpha Baupost S&P 500 TR Four Factor Alpha

All Stock Picks 1.30% 0.32% 54 bps/month 0.86% 0.29% 6 bps/month

Top 10 Stock Picks 1.18% 0.32% 44 bps/month 0.79% 0.29% 3 bps/month

Top 5 Stock Picks 0.96% 0.32% 25 bps/month 0.51% 0.29% -15 bps/month

Large-cap Stock Picks ($20+

Billion) -0.10% -0.21% NA -0.60% -0.49% NA

Mid-cap and Small-cap Stock

Picks ($1B - $20B) 1.47% 0.32% 101 bps/month 0.57% 0.29% -18 bps/month

Micro-cap Stock Picks (Less

Than $1B) 1.53% 0.32% 65 bps/month 1.09% 0.29% 28 bps/month

Top 5 Micro-cap Stock Picks 1.38% 0.32% 41 bps/month 0.74% 0.29% -26 bps/month

Value-weighted Avg. Monthly

Returns

1999-2012 2008-2012



Top 10 Stock Picks 1.30% 0.32% 56 bps/month 0.98% 0.29% 21 bps/month



Billion) -0.03% -0.21% NA -0.15% -0.49% NA


Picks ($1B - $20B) 1.58% 0.32% 108 bps/month 0.93% 0.29% 2 bps/month



Top 5 Micro-cap Stock Picks 1.36% 0.32% 42 bps/month 0.96% 0.29% -16 bps/month

Equal-weighted Avg. Monthly

Returns

1999-2012 2008-2012


Klarman’s outperformance in the micro-cap space might be a result of his biotechinvestments. As you may know biotech stocks performed much better than the marketover the 1999-2012 period. We calculated Klarman’s returns after excluding hishealthcare stock picks. The results actually improved:

Klarman’s healthcare stock picks generated an annual return of more than 16% between 1999 and 2012. Onthe surface this seems like a good performance. However, investors would have outperformed Klarman’s picksby double digits annually by randomly investing in other healthcare stocks that have similar size, value, andmomentum characteristics.

These results also explain why Klarman’s recent performance wasn’t satisfactory. Micron and Cheniere Energybelonged to the large-cap space which Klarman doesn’t have an edge. Keryx is a micro-cap biotech stock andKlarman weren’t able to generate positive alpha in this space on average.







Billion) -0.19% -0.21% NA -0.44% -0.49% NA


Picks ($1B - $20B) 1.55% 0.32% 104 bps/month 0.76% 0.29% -18 bps/month



Top 5 Micro-cap Stock Picks 1.91% 0.32% 100 bps/month 2.25% 0.29% 140 bps/month

1999-2012 2008-2012Equal-weighted Avg. Monthly

Returns (Non-Healthcare)

It is actually a bit surprising to see these results. Klarman’s non-healthcare stock picks performed better thanhis healthcare stock picks even in a period when healthcare stocks were beating the market by a large margin.Now, finally let’s take a look at the performance of Baupost’s healthcare picks:

Baupost S&P 500 TR

Four Factor Alpha

with Sector Adj. Baupost S&P 500 TR

Four Factor

Alpha with Sector

Adj.

All Healthcare Stock Picks

(Value-weighted) 1.35% 0.29% -99 bps/month 1.10% 0.29% -38 bps/month

Top 5 Healthcare Stock Picks

(Value-weighted) 1.37% 0.29% -97 bps/month 1.15% 0.29% -32 bps/month

Top 5 Healthcare Stock Picks

(Equal-weighted) 1.25% 0.29% -99 bps/month 0.94% 0.29% 16 bps/month

Top 5 Micro-cap Healthcare

Stock Picks (Value-weighted) 1.41% 0.29% -112 bps/month 1.20% 0.29% -103 bps/month

1999-2012 2008-2012


We conclude that the best stocks to invest in Seth Klarman’s portfolio are his top 5 non-healthcare stock picks. Here is the report card for the performance of these stocksbetween 2008 and 2012:

This strategy’s volatility is almost twice as much as the volatility of the S&P 500 index. However itoutperformed the S&P 500 Index by nearly 2 percentage points per month on average. It underperformed themarket in 2011 and 2012 by small margins.

Based on the latest 13F filings here are the top 5 micro-cap non-healthcare and healthcare stocks in Klarman’sportfolio:

Check out Baupost’s Latest 13F Portfolio.


Performance/Risk Metrics

Baupost

Strategy SPY

Avg. No of Stocks 5.0 500

Average Monthly Return 2.25% 0.29%

Monthly Std. Deviation 10.5% 5.5%

Best Month 42.7% 10.9%

Worst Month -24.9% -16.5%

Maximum Drawdown -45.7% -46.3%

Sharpe Ratio 0.83 0.16

2008 Return -31.1% -36.8%

2009 Return 111.4% 26.3%

2010 Return 73.1% 15.1%

2011 Return 1.2% 1.9%

2012 Return 10.0% 16.0%

CompanyName Ticker

SH/

PRN Option

Value

(x1000) Activity

% in

Portfolio

% of Market

Cap Sector

KERYX BIOPHARMACEUTICALS INC KERX SH N 170741 0% 2.3% 24.4% Health Care

ATARA BIOTHERAPEUTICS INC ATRA SH N 120645 0% 1.6% 18.6% Health Care

VERITIV CORP VRTV SH N 114408 0% 1.6% 19.0% Consumer Services

FORWARD PHARMA A/S FWP SH N 97524 0% 1.3% 11.7% Health Care

CHIPMOS TECHNOLOGIES IMOS SH N 67946 0% 0.9% 13.8% Technology

SUNEDISON SEMICONDUCTOR LTD SEMI SH N 49652 0% 0.7% 19.9% Technology

SILVER RUN ACQUISITION CORP SRAQ SH N 36750 New 0.5% 6.0% Finance

PARATEK PHARMACEUTICALS INC PRTK SH N 28439 32% 0.4% 11.5% Health Care

CASCADIAN THERAPEUTICS INC CASC SH N 23578 New 0.3% 26.2% Health Care

SUNRUN INC RUN SH N 16889 0% 0.2% 2.8% Capital Goods

http://www.insidermonkey.com/hedge-fund/baupost+group/7/

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