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Three top stock picks from Middlefield’s Dean Orrico and SSR’s Richard Evans

Vietnam’s pharmaceutical market is forecast to increase to $7.2-billion (U.S.) by 2020 from $4.2-billion in 2015.

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Dean Orrico is president and chief investment officer at Middlefield Capital. Richard Evans is head of healthcare practice at SSR. Their focus is health care stocks.

Top Picks:

Medtronic (MDT-N)

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Medtronic is a global leader in medical technology product sales, with one of the strongest management teams in the industry. The company is at the beginning of an exciting new product cycle which will drive growth. Over the long-term, management has guided to mid-single-digit revenue growth and double-digit EPS growth. We expect the company to grow earnings at a double-digit rate through 2020, driven in part by the rapidly expanding TAVR market. For 2017, management is targeting 130-200 basis points of margin improvement. Management expects the company to generate $40-billion of free cash flow over the next five years, half of which will be returned to shareholders through dividends and buybacks, and half used for M&A, debt reduction and financial flexibility. The stock trades at a very reasonable valuation of 17.8x 2017 EPS, a slight discount to its large-cap peers, and pays an attractive 2-per-cent dividend yield.

Roche (ROG.VTX)

Roche is a global pharmaceutical company focused on oncology. The company has one of the largest R&D budgets in the industry, both in absolute and relative terms, and has an exceptional long-term drug pipeline, which SSR believes is undervalued by the equity market. In the near term, the company expects to grow earnings at mid-single digits. In part due to slower near-term growth, the stock trades at 15x 2017 EPS, a discount to European pharma peers, and pays a very attractive 3.4-per-cent dividend. The company has increased its dividend for 29 consecutive years, and management expects this trend to continue.

Rite Aid (RAD-N)

The company is being acquired by Walgreen's for $9 (U.S.) per share in an all-cash transaction. Based on U.S. federal proximity standards, the pharmacy industry is very over-supplied and requires consolidation going forward. The oversupply of pharmacies was due in part to the growth in dispensing margins, which were the fastest growing segment of any retailer for the past decade and are now in decline. Based on established federal guidelines, we believe that the combined entity would need to divest between 400-500 of the 8200 stores acquired to win approval from the regulators. Shortly after the transaction was announced, Walgreen's management had stated they were willing to divest up to 1,000 stores, so we believe that management is willing to be very cooperative with regulators to get the deal approved. The past 12 months has seen a record number of M&A deals fall apart in the United States, causing deals to trade at very wide spreads. We believe the current spread of over 20 per cent is very attractive, and offers very compelling risk/reward as the transaction is expected to close in the coming months.

No Past Picks – First Appearance on Market Call

Market outlook:

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Since we're in a relatively low-growth world in developed economies, we believe interest rates will remain low for the foreseeable future. Even if the Federal Reserve doesn't increase rates in December, we believe there's a high likelihood that they do raise at least once over the next 6-9 months. This type of macro environment favours equities over fixed income with an advantage to dividend-paying stocks. As a result, we believe pipeline and power producers, along with REITs, are well-positioned in the current market. Given the pullback in REITs over the past few weeks, we believe they are very attractively valued.

In light of all the political rhetoric surrounding drug pricing in the U.S., health care equities, which had been perennial outperformers on an absolute and risk-adjusted basis, have pulled back. As a result, health care stocks are currently trading at a discount to the broader market with greater earnings growth potential. We believe this has created a very attractive investment entry point for traditional pharmaceutical companies. In addition, we work closely with Dr. Richard Evans and his team at SSR to identify those pharmaceutical companies who have significant hidden value in their drug pipelines. The methodology utilized by Dr. Evans is proprietary to his firm and has been developed over many years as a result of his experience at Roche and as the pharmaceuticals analyst at Sanford Bernstein, where he was ranked No. 1 in the country.

Since we believe energy prices bottomed in February of this year, we have gradually increased our energy exposure over the past several months. The current talk around an OPEC production freeze has supported this view. We are focused on dividend-paying energy equities who are low-cost operators. The recent surge in natural gas prices is also driving gas-weighted equities higher.

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