I am quite sure that most investors have heard of the biotech industry and the explosive profit potential that exists within the realm when a small company develops a new and exciting blockbuster drug. In addition, I am almost certain that very few of us have the medical and technical expertise to make even educated speculations as to which ones from the multitudes of small biotech companies have the realistic potential to deliver one of these homerun products and that makes it a very risky place to allocate our capital.
I think what a lot of smaller, individual investors tend to overlook at times is the opportunity to eliminate a good portion of the risk involved in biotech investing while still retaining the potential for astounding gains. This can often be accomplished by investing in biotech businesses that have existing products already producing strong earnings and a continuing stream of approvals for new drugs to serve an existing demand.
Of course, for a value investor, the stock must also be trading at attractive valuations to provide the potential for exceptional returns with limited risk. I think I have found that situation to exist today in shares of Gilead Sciences Inc. (NASDAQ:GILD).
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How Does Gilead Meet The Criteria Shown Above?
Gilead is a biotech drug company focused on the development, marketing and distribution of drugs targeted at treating HIV, Hepatitis B & C, liver diseases, respiratory and cardiovascular/metabolic ailments. These are all afflictions that have been with us for a long time and seem poised to remain with us for a long time into the future. For the most part, they are also maladies which can be treated with some degree of effectiveness, but not cured.
While the existence of treatments, without the existence of cures is at least some good news for those afflicted, it is great news for potential investors as it means the existence of long-term customers. This view may sound cold and calculating; but, in reality, it is just a fact. The patients are far better off because the drugs exist and the investors are better off selling treatments rather than cures. It doesn’t mean a cure is not sought; it just means we do not have to wait until that is accomplished in order to profit. As investors, however, it would be foolish not to recognize the value in producing treatment regimens for chronic diseases rather than being focused on cures.
Gilead has an active pipeline and is also constantly expanding the uses for existing products as evidenced by the recent volume of activity in these areas. While new drug development is important, expanding the use profile of existing products is much more profitable as it requires less expense on the development and testing side.
What Is The Safety Factor Gilead Provides For Investors?
As value oriented investors, we are always concerned with the safety of the capital we allocate to various businesses. Simply put, we do not like to lose money. I know everyone says that; but, watching the way many people throw money at various stocks with no real concept of why they are making the investment or why the stock should move higher, I do not believe they hate losing money as much as they claim. I HATE losing money; I get mad at myself when I do. I also insists on reviewing every loss to find out what I missed in my original analysis that caused my valuation to be flawed.
As of March 31, 2014, Gilead was showing cash and short-term investments of $6.469 billion on their balance sheet. In addition, they have $3.236 billion of receivables and $2.140 billion of inventory. This is twice the level of their current liabilities of $5.915 billion.
Over the past five years, Gilead has produced average annual returns on equity, assets and capital of 40.8%, 21.1% and 27.4% respectively. There is no other way to describe this level of performance from a $139 billion business than spectacular.
The business has grown at a blistering pace over the past 10 years from sales of $1.32 billion in 2004 to $11.2 billion in 2013. The corporate income has followed a similar path, having increased from $449.37 million in 2004 to $3.07 billion in 2013.
With a rock solid balance sheet and extraordinary 10-year track record of results, Gilead has all the earmarks of a safe home for investors’ capital in the hands of people who know what to do with it.
We Have Seen The Safety; Now, Show Me The Money!
Safety is a crucial aspect of any investment I consider; but, I never forget that the primary objective of investing is the generate profits. I seek to accomplish this objective by finding businesses that are currently undervalued relative to my estimate of fair value or businesses that are grossly undervalued based upon their prospects for future growth. Gilead delivers on both counts.
Based upon consensus analysts’ projections for 2014 and 2015, Gilead carries P/E multiples of 14.58 and 10.69 respectively. These valuations are significantly less than the S&P 500 estimate of 19.62 for 2014 as of July 25th. It is difficult for me to believe that a business with the product niche held by Gilead should be trading at a discount of 25% to the S&P 500 based upon any metric, much less one as common as a P/E ratio. Based upon Gilead simply being valued on par with the average business in the S&P 500, a 19.62 earnings multiple against the $6.21/share projected by analysts covering the stock results in a fair price of $121.84 or 35.6% higher than the current share price of $89.84.
But, one metric of value is not sufficient in attempting to assess fair values and reported earnings are noted for the ease with which they can be manipulated by accountants. I used to have a financial manager at a business unit I led who, when queried on his expectations for our earnings in a given period, would smile and say: “What do you want them to be?” It was a tongue in cheek comment but did contain a certain element of truth as anyone who has led a significant business can assure you. 5-year returns on equity, assets and capital are less easily changed.
I like to take the average of the 5-year returns on equity, assets and capital and then multiply the result by the projected earnings for the current and next year and use those figures as one of my metrics for establishing fair value of a business. After all, these numbers reflect the real results management has delivered with the capital and assets under their control and how rapidly they have increased the value of the portion of the business owned free and clear by the shareholders.
In this regard, the average of the 5-year returns on equity, assets and capital is 29.7. If this result is multiplied by the current year’s projected earnings of $6.21/share, a fair value figure of $184.85 results. Interestingly enough, one of the most common valuation metrics used by investors is to multiply the current year’s projected earnings by the projected 5-year earnings growth rate. In the case of Gilead, the analysts covering the stock are estimating that the earnings will grow at an annual pace of 31.3% annually over the next five years. This metric results in an estimated fair value of $194.37/share for the stock. Both of these calculations indicate the stock as a potential double from the current price.
But I Promised A Dividend That Gilead Does Not Pay
As they say, there is more than one way to skin a cat (or collect a dividend). Today, I am going to show you two ways to get a dividend that most investors will never consider in their entire life. If you agree with this analysis and find Gilead to offer a compelling value at the current price, then there are two ways to potentially open a position in the stock while simultaneously creating a synthetic dividend in the stock. I read a study that claimed 41.8% of all stock market gains since 1930 have come from dividends; therefore, I think we should get them if we can.
When I write about creating synthetic dividends, I am referring to my fondness for selling options against stocks I own or wish to own. There are two primary types of option contracts I sell, naked puts and covered calls.
Selling a put option simply obligates me to purchase 100 shares of the underlying stock on or before a certain future date and at a specified price at the sole discretion of the buyer. In exchange for agreeing to buy the shares covered by the option, the option buyer will pay me a premium.
In the case of Gilead, the current bid for the August 16, 2014 expiration $87.50 strike price put option is $1.39/share or 1.58% of the strike price. The strike price represents a 2.6% discount to the current market price of the stock. For each option contract sold, investors could be obligated to purchase 100 shares of the stock at a price of $8,750, if the stock is trading below $87.50 on August 16th. However, after subtracting the premium collected from selling the options, the actual breakeven point for the option seller would be a share price of $87.5-$1.39 or $86.11, a discount of 4.15% to the current price. If the stock is trading above $87.50 on August 16th, there would be no reason for the person who bought them to sell me shares below the current market price so I would just keep the 1.58% premium collected from the sale. If I did this once a month for a year, I would earn 18.96% on my capital without ever owning a share of stock!
Selling a covered call option obligates the option seller to deliver to the buyer, at the buyer’s option, 100 shares of the underlying stock, at the agree upon “strike price”, at any time between the sale of the option and the expiration date. As of this writing, the August 16, 2014 expiration call options on Gilead, with a $95 strike price has a bid price of $0.60/share, representing an immediate “dividend” of 0.66% on the $89.84 share price. Collecting this “dividend” each month for a year, would result in a “yield” of 8.01%. Sellers of this option would sell one contract for each 100 shares of Gilead they own. In order for the option buyer to wish to exercise their right to take the shares, the stock would need to be trading over $95 by August 16th. This would represent an additional capital gain of 5.74% from the current share price for a total one month return of 6.4%.
Closing Thoughts And Actionable Conclusions
Based upon its current valuation, past performance and future prospects, Gilead Sciences appears to have a current valuation seriously below it fair price. It represents a compelling value today even for the most selective of investors with a strict buy and hold approach to portfolio management.
In the case of those investors who demand discounts on everything they buy, regardless of current price to value ratios, selling a naked put contract for each 100 shares desired with a strike price of $87.50 and an expiration date of August 16th offer an exceptional discount to the current price in the time covered and allows discount buyers to be paid quite well while they wait for better pricing.
Income oriented investors who love to collect dividends, even from businesses that do not pay them, should give serious consideration to buying the shares at the market and selling one August 16 expiration call option for each 100 shares of the stock they buy to begin collecting their 8.01% “dividend yield” on a stellar investment opportunity.
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About the author:
He is a full-time copywriter as well as a freelance contributor to several investment related websites.
Ken also prepares analysis pieces of individual stocks on a contract basis for other individual investors.