2 Picks from an Investment Pro with 20% Annual Gains

The stock market has seen plenty of ups and downs in the past 25 years. Through it all, hedge fund Baupost Group’s Seth Klarman has managed to stay on the right side of the ledger, racking up an average annual gain of about 20%.

As I recently discussed, the power of compounding can work magic with numbers like that. If you invested $10,000 with Klarman back in 1985, it would be worth about $950,000 today. Most impressively, he’s bagged those returns with the relative safety of value stocks, eschewing the stomach-churning gyrations of growth stocks. And Klarman often holds lots of cash, making those returns even more stunning. Even if you’re not one of Klarman’s clients, you can still piggyback on his efforts by reading up on his latest moves.

A recently-released 13F report from the U.S. Securities and Exchange commission points to a pair of new names in Klarman’s portfolio that look quite intriguing.

Aveo Pharma (Nasdaq: AVEO)
Despite his predilection for value stocks, Klarman likely sees a potential blockbuster with little-known Aveo Pharma. He bought 2 million shares last quarter, worth about $28 million. Aveo is developing a range of cancer-fighting drugs, led by tivozanib, which inhibits vascular endothelial growth factor (VEGF). VEGF allows for the creation of new blood cells that can provide a lifeline to cancer cells. Cut back on VEGF, and you can shrink or eliminate tumors.

Aveo has a ways to go before fulfilling its promise. Tivozanib showed very promising results in a Phase 1 clinical trial with the U.S. Food and Drug Administration, but the next two phases of testing will be far more rigorous. Even if everything goes according to plan, it will be several years before tivozanob hits the market, though Klarman may be betting on Aveo being acquired well before then. These days, any biotech firm with a potentially promising drug in development seems to be buyout bait for larger pharmaceutical companies facing costly patent expirations on their existing blockbuster drugs.

Klarman’s play here is already on the move. Japan’s Astellas said it will pay Aveo $575 million if tivonazib is approved, and potentially $780 million more if sales targets are met. After the news, Aveo’s value rose more than $100 million to about $600 million on Thursday, Feb 17, well below the potential value created by the Astellas endorsement.

PDL BioPharma (Nasdaq: PDLI)
This biotech play has seen better days. Shares traded above $30 back in 2006, but now trade for less than $5. Klarman originally owned this stock back in 2008, but sold off his stake in the summer of 2009 at a loss. Shares have drifted yet lower since then, leading Klarman to jump back in, buying 5.6 million shares in the last quarter, which are currently worth about $30 million.

PDL holds the patent to a number of antibody technologies that are used by other drug companies with their drugs. Klarman’s latest buy comes at a time when the company is pursuing a potentially large legal settlement. PDL is seeking unpaid royalties from Roche’s Genentech division. Some suspect that Genentech may be liable for hundreds of millions in royalty payments if PDL prevails in a current lawsuit.

Besides this potentially big upside event, PDL typically generates $300 to $400 million a year in sales and earns roughly $1 a share. Not bad for a $5 stock. Shares are so cheap because PDL’s key intellectual property rights will lose patent protection in 2014. To offset that cliff, the company is working on a range of new drugs that are currently undergoing clinical trials.

Shares are also being discounted after PDL agreed to pay AstraZeneca’s (NYSE: AZN) MedImmune division $92.5 million to settle a royalty dispute regarding PDL’s virus treatment Synagis. Klarman, who bought shares at slightly higher levels, may not have seen this coming as courts had ruled in MedImmune’s favor last month — after Klarman bought into PDL. Some had seen the MedImmune dispute as an overhang to the stock, and with the bad news out of the way, shares may finally start to post the upside that Klarman envisions.

Beyond potential capital appreciation, Klarman and others see PDL as a near-term solid dividend play. PDL issued a pair of $0.50 dividends in 2010 (equating to a combined 18% dividend yield), and analysts think the company will issue at least $0.50 in dividends this year (equating to a 9% yield). That Genentech legal squabble — if resolved in favor of PDL — appears to represent the major upside for this stock. In its absence, the stock is only worth about $7, according to some analysts. Even that is a 40% upside from current levels.

Action to Take –> Seth Klarman may not be as well known as Warren Buffett or John Paulson. But he should be. He has an uncanny knack for picking winners, and these two new positions, though they are a small part of his portfolio, could help to fuel yet another strong year for one of the Street’s most consistently winning investors.