Here’s How Palo Alto Investors Returned 26.2% Last Quarter

Palo Alto Investors, managed by William Leland Edwards, was one of the most successful hedge funds last quarter, at least in terms of returns generated, gaining 26.2% between March 31st and June 30th. Now, it’s worth mentioning that we can only track Palo Alto’s 13F portfolio, i.e. the quarterly positions the fund reports to the SEC, but a return in the twenties is impressive no matter how you slice it. Interestingly, Edward’s hedge fund is nearly entirely focused in healthcare stocks (as this graph shows), with over 90% of its total holdings held in this sector.

Consequently, individual investors would be wise to take note of the manager’s best gainers over this time period; it may not be too late to add them to your portfolio. Below are Palo Alto’s top two stock picks, in order of largest to smallest.

Onyx Pharmaceuticals, Inc. (NASDAQ:ONXX)

Onyx Pharmaceuticals, Inc. (NASDAQ:ONXX)

Currently taking the number one spot in Edwards’s portfolio, Palo Alto holds 2.3 million shares of this biopharmaceutical company worth a total of nearly $180 million, or 16.9% of its total 13F portfolio. Since the start of 2012, shares of Onyx Pharmaceuticals have returned an impressive 74.5%, primarily due to an FDA approval of Kyprolis, a drug used to treat multiple myeloma.

While the company did disappoint with its trial failure of Nexavar, a much-hyped liver cancer drug, Kyprolis is expected to generate $25 million in revenue by the end of this year, while growing to $600 million by 2015. It appears that these top line estimates are driving Onyx’s stock price toward the $80-$85 range, though bulls must be aware of the company’s earnings overvaluation, and shoddy EPS forecasts.

Interestingly, Onyx has seen a bit of insider selling over the past few weeks, from the likes of M. Suzanne Shema, Helen Torley, Paul Goddard, G. Thomas Wiggans and Wendall Wierenga. Since August 16th, these five insiders have sold a combined 27,600 shares of the biopharmaceutical company at an average price of $72.31 a piece. This round of selling activity is likely profit taking at its finest, as each insider exercised options worth an average price in the $31-$32 range, making for a nice payday.

On the whole, we like Onyx Pharmaceuticals, primarily due to its advantageous revenue forecasts from Kyprolis, which is coincidentally the first drug ever to be completely owned by the company. Due to the fact that this stock makes up over one-sixth of Palo Alto Investors’ 13F portfolio, it’s possible that we’ll see the fund atop the charts once again at the end of this quarter.

Cyberonics, Inc. (NASDAQ:CYBX)

Cyberonics is a small cap medical devices company, with a focus on the production of systems that aid in the treatment of epilepsy and other neurological disorders. As of the end of last quarter, Palo Alto held 2.3 million shares worth $105.6 million in the stock. Cyberonics’ “star product,” so to speak, is its NeuroCybernetic Prosthesis System, which has been approved by the FDA to treat seizures. Over the past nine months, shares of the company have generated a near 50% return, and it also impressed in its most recent quarterly earnings report.

Specifically, Cyberonics reached a first quarter (FY 2013) net income of $8.1 million, for an EPS of 29 cents a share. These results were up 20.8% on a year-over-year basis, and 17.0% on a quarterly basis. By the end of its current fiscal year, Cyberonics is expecting to reach earnings between $1.49 and $1.59 a share, with the Street’s forecasts falling right in line with this guidance.

If its average target EPS is reached, fairly valued shares of Cyberonics can see moderate appreciation over the next 12-16 months, as it looks to be undervalued in terms of its earnings growth. The company’s stock currently trades at a PEG ratio of 1.33, below Medtronic, Inc. (NYSE:MDT) at 2.10, Stryker Corporation (NYSE:SYK) at 1.42, and St. Jude Medical, Inc. (NYSE:STJ) at 1.62. Interestingly, Cyberonics expects to blow these competitors out of the water in terms of earnings growth, which is projected to average 28.3% a year over the next half decade. This is below the likes of Medtronic (6.2%), Stryker (10.8%), and St. Jude Medical (10.3%) quite significantly.

Aside from Palo Alto Investors, other hedge funds that are long Cyberonics are prominent managers such as Richard Driehaus, Mike Vranos, and Jim Simons. Like Onyx Pharmaceuticals, Cyberonics provides investors with a strong momentum play at an attractive price. It is understandable how this dynamic duo of healthcare stocks helped Palo Alto achieve such impressive returns last quarter.

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