Idea generation is a process that we are continually reflecting upon and refining. A mindset of continuous observation, creativity, passion for business, and attention to both the quantitative and qualitative elements of investing surround this process, which tends to be iterative in nature. We would like to end off 2021 by dissecting an investment idea from start to finish – how we identified the idea, the investment process itself, the research and diligence into the idea including a discussion with management, and how, in the end, we crystallized value as it approached our fair value target. Because investing tends to be fluid in nature, we also discuss opportunistic juncture points at which we responded to market perceptions and how the data/information at hand shaped our decisions.
In the healthcare sector, there has been a technological evolution in the way care is delivered to patients, how outcomes are measured, and how patient economics can be improved while increase the quality of care. This has given rise to the notion of connected data, in which patient data can be used individually and in aggregate to improve provider decision making and identify solutions at the patient population level. In June of 2020, we initiated a position in a company – named Inovalon – that connects this data together, unifying the knowledge sharing between patients, providers, and managed care companies. Inovalon owns the data infrastructure used in gathering, anonymizing, and synthesizing patient data into healthcare insights that can then be applied across the population. We first identified this idea via researching the characteristics of various healthcare niches – different segments of the healthcare industry that have utilitarian characteristics which we felt would eventually evolve into a recurring revenue profile. At the time we identified Inovalon, the company was relatively young, starting to gain traction in the large managed care market, and run by a visionary owner operator, Dr. Keith Dunleavy MD. We had the opportunity to speak with Dr. Dunleavy, who answered our questions on the dynamics of the healthcare data analytics market, explained the longevity of the growth ahead of the company in an increasingly complex industry, and described details of a partnership with Walmart that the company had recently entered into to improve patient outcomes in specialty pharmaceuticals.
Results soon started to crystallize. The company’s annual contract value (ACV) started to expand, the pipeline of new business opportunities continued to broaden, and investor interest in the growing segments of laboratory sciences and specialty pharmaceuticals started to grow. The shares soon appreciated from $17 to $25. At this juncture point, investor attention started to focus on the immediacy of near term results. In Q3 of 2020, earnings and revenues actually surpassed expectations but the recurring revenue profile was slower to materialize due to large enterprises giving more thought to their decision making processes. The shares reverted from $25 to $19, at which time we recognized the temporary nature of the dislocation and decided to retain our position size. The subsequent quarter, revenues re-accelerated, large enterprises returned to the pipeline, and the shares appreciated back to their former $25 level. Still, recognizing greater longevity in the business, we decided to remain disciplined in our valuation outlook of $35 and continued holding the shares in client portfolios.
In 2021, investor attention continued to focus on the scalability of the business model and its recurring revenue generation capability. The shares entered a phase of steady, less volatile capital appreciation. Soon after, private equity interest started to materialize, and the same attractive features we had originally identified in Inovalon – recurring revenue, owner-operator led, targeting a large and growing industry – were also found to be attractive by this private equity firm. Cash terms of $41/share were offered for Inovalon in August 2021, at which point we exited our position for a +141% return. The core investment principles we applied included: 1) Being disciplined in our valuation outlook; 2) Mindful of risk management, especially at earnings junctures where surprises created opportunities at the same time as elevated volatility; and 3) Identifying the underlying characteristics of a recurring revenue, owner-operator led business, and remaining patient throughout the emerging growth phase of a business.
As discussed earlier, investing is an iterative process in which our idea generation is being continually refined. This helps us construct a portfolio of businesses – each with their own niche characteristics – that have the highest probability of translating into eventual, compounding earnings growth. Reflecting on our experience with Inovalon, companies that are targeting large and growing industries, capable of scaling to create repeat business, and run by founder-led visionaries attract increasing investor interest. The aim of our small cap portfolio is to identify such ideas, early enough in their growth lifecycles, that their eventual maturity profiles will warrant valuations that reflect stable and compounding growth.
We hope clients have enjoyed this installment about investment decision making, and we wish you a joyful Christmas and a Happy New Year.
Warmest regards,
Grace, Sam, Leslie and Jennifer