Dividend and Value Opportunities in the Large-Cap Pharmaceutical Space

How to identify Ben Graham- and Joel Greenblatt-type investments

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Apr 05, 2016
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The health care sector and in particular pharmaceutical companies have underperformed recently. The chart below shows the performance of the health care sector (as represented by the XLV ETF) versus the Standard & Poor's 500 for the beginning of 2016.

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As a result of this underperformance, both this year and the previous year, large-cap pharmaceuticals are trading at valuations well below both their historical average and that of the larger market.

The underperformance of the sector seemed to start with comments made last year (and repeated several times) by Hillary Clinton (currently the odds-on favorite to win the Democratic Party's presidential nomination) regarding high drug prices and the saga surrounding Martin Shkreli and the price increases he enacted at Turing Pharmaceuticals. The epic meltdown of large-cap pharmaceutical rollup Valeant Pharmaceuticals (VRX) also probably contributed toward traders and investors shying away from the health care sector.

Despite all this, the pharmaceutical space is an attractive one in which to invest as many companies generate high returns on capital. The wide economic moats provided by patent-protected intellectual property allow the sector to generate substantial free cash flow. Additionally most well-behaved large cap pharmaceutical companies do not depend on doubling, tripling or even more the prices of the drugs they sell as Valeant and Turing did to generate revenue growth. Instead, the companies research and develop new drugs and bring them to market. While the companies are able to sell their drugs for higher prices in the U.S. (for a variety of reasons), abroad we see no signs that will change any time soon. Saying something on the campaign trail is one thing; enacting legislation is another.

The problem for many investors is that investing in the pharmaceutical sector requires a lot of specialized knowledge. It is difficult for those without a scientific background to analyze a company’s drug pipeline. In fact, it’s so difficult that even those with advanced degrees in medicine, biology, chemistry or other related disciplines seem to be unable to make consistently accurate forecasts. Given the high degree of uncertainty in predicting future sales for pharmaceutical companies, investors might want to consider a more Benjamin Graham or Joel Greenblatt (Trades, Portfolio) approach to investing in the pharmaceutical sector.

Investors might consider buying a basket of companies whose stock prices imply expectations below consensus results. That is, instead of trying to predict which companies and which drugs will be successful, we are instead just buying a basket of stocks with low expectations and banking on the future not being as bad as the market expects. We’ve had some success with this approach in the past so we thought we’d share the methodology with readers using 11 major large-cap pharmaceutical companies a san example.

The first thing we did was construct reverse DCF models for all 11 companies. We chose AbbVie (ABBV, Financial), AstraZeneca (AZN, Financial), Bristol-Myers-Squibb (BMY, Financial), GlaxoSmithKline (GSK, Financial), Johnson & Johnson (JNJ, Financial), Eli Lilly (LLY, Financial), Merck (MRK, Financial), Pfizer (PFE, Financial), Roche (RHHBY, Financial) and Sanofi (SNY, Financial). You can, of course, compile your own models including any companies we skipped over (such as Gilead Sciences [GILD], etc.).

For our DCF model we used a terminal growth rate of 3% and a discount rate of 10%. We chose a discount rate of 10% because the long-term average return of the stock market is around 10%. Our discount rate was not chosen to reflect any risk or uncertainty in the future cash flows of the companies. We then took each stock's trailing 12-month working capital-adjusted free cash flow and looked at what five-year and 10-year growth rates were needed to justify the company’s current stock price.

The chart below shows the implied short-term DCF growth rate (five-year and 10-year average), the consensus five-year EPS growth rate taken from Yahoo! (YHOO) Finance and the consensus five-year EPS growth rate taken from a major Wall Street brokerage report on the pharmaceutical sector (labeled “Street Estimate”).

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We’ve highlighted in red the three stocks with the highest negative difference between what the stock price implies and what the experts predict. We’ve highlighted in green the stocks with the highest positive difference between what the DCF model implies and what the experts predict.

For example in order to justify its current stock price Merck needs to grow at around 0% for the next five years. However, experts predict Merck’s earnings will grow at around 4% to 7%. If Merck is able to even get close to that growth figure, the stock should outperform.

On the other hand Eli Lilly needs to grow at around 15% for the next five years to justify its stock price. Experts are predicting just 12% to 13% growth from the company. One misstep at Eli Lilly, and the stock could miss expectations and underperform.

Before just going out and buying a group of the most attractively priced stocks, it’s important to keep in mind that many pharmaceutical and health care companies are constantly buying and selling assets. For example GlaxoSmithKline and Novartis (NVS, Financial) recently completed a major asset swap, switching their vaccine and oncology businesses and forming a new consumer health care joint venture. Some of the analyst estimates (specifically from free sources such as Yahoo!) may not accurately reflect the current state of the company.

Likewise, trailing 12-month cash flow numbers also might not include a full year of a company’s newly acquired business lines. Thus, it’s important to research each company that the initial screening methodology identifies to make sure the numbers you’re using are accurate.

Investors looking for income will also find the pharmaceutical sector a great source of dividends. The table below shows the yield for the 11 stocks we examined along with the current payout ratio. The average yield for the sector is well above the market.

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(Data from Bloomberg.com and Morningstar)

While the payout ratio for some stocks such as Bristol-Myers-Squibb is above 100%, it’s important to remember that in the future the dividend will likely be covered as the company is expected to grow earnings at a double-digit clip due in large part to the expected success of its cancer drug Opdivo. However, as we explained earlier it may not be wise to count on earnings growth turning out the way analysts estimate. A combination of stocks with high dividends, low payout ratios and low implied earnings growth makes for an excellent basket of investments.

Because of the inherent uncertainty in the pharmaceutical sector and difficulty in making accurate predictions about the future, we think it’s prudent to invest in a basket of companies and follow a value-oriented approach by buying the ones with the most muted expectations.

Disclosure: Long GlaxoSmithKline, Novartis, Roche and Johnson & Johnson.