Gurus Invest in Top Biotechnology Stocks

Graham's Lost Formula unearths biotech gem; many guru buys occur

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Jun 20, 2016
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Throughout the first quarter, many gurus have increased their positions in top-performing biotechnology stocks, suggesting that the biotechnology sector contains some hot opportunities to increase portfolio returns. One of the hottest biotech stocks, United Therapeutics Corp. (UTHR, Financial), is currently owned by seven gurus. Additionally, four gurus increased their position in United Therapeutics, one of eight biotechnology stocks listed on the Ben Graham’s Lost Formula I Screener.

A lost 'magic formula?'

In the early 1900s, an intelligent investor named Ben Graham became a famous Wall Street icon, according to a June 2007 research article on Graham. Throughout his investing career, the “Father of Value Investing” explored the simplest way to search for bargain stocks. During his final three years, Graham introduced a simple formula for choosing the bargain stocks:

  • These stocks have trailing 12-month P/E ratios less than 7 to 10.
  • The equity-to-asset ratio of these stocks is at least 0.5.

Although his formula was not found in his investment books, the intelligent investor discussed the formula in a "Medical Economics" interview published the day before his death, Sept. 21, 1976. When Graham back tested the formula from 1926 to 1976, his magic formula beat the Dow by 100% (investors could have realized a return twice that of the index return by following this formula). However, Graham’s magic formula would not be published in his investment book "Security Analysis"Â 12 years later.

Opportunities exist in undervalued biotech industry

Today, Graham’s magic formula listed eight biotechnology stocks that have an equity-to-asset ratio of at least 0.5. Among these stocks, only two of them, United Therapeutics and Ligand Pharmaceuticals Inc. (LGND, Financial), have positive operating margins. Despite having just a one-star predictability rank, these two biotech companies have high financial strength and profitability.

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Although the biotech industry has the lowest median operating margin, more gurus have been buying than selling biotech stocks in the past three months. According to the consensus picks of gurus, 21 biotech stocks have been bought by at least four gurus, owned by at least six gurus and sold by at most three gurus in the past three months. With the highest combined weighting of 2%, Agilent Technologies Inc. (A, Financial) has been owned by 13 gurus in the past three months. Furthermore, the biotechnology sector has 147 buys and 137 sells, according to the aggregate trend of gurus.

United Therapeutics: a growing biotech company

Incorporated in Delaware, the 1996 biotech company provides therapeutic products and services to serve patients with chronic or life-threatening diseases. Historically, United Therapeutics has experienced high operating margins and per share revenue growth, suggesting that the firm has high upside potential. Currently, United Therapeutics’ financial strength and profitability rankings are high, 9 out 10.

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Although the company had decreasing operating margins from 2006 to 2009, United Therapeutics experienced expanding operating margins since 2009. As of March, the biotech company has an operating margin of 98.56% that outperforms 98% of global biotech stocks. The company’s operating margin is expanding: its five-year operating margin growth rate is a healthy 6.40% per year. Additionally, the firm has increasing returns on equity and Greenblatt return on capital. Currently, United Therapeutics has a higher ROE and Greenblatt ROC than 98% of companies in the global biotech industry.

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With a financial strength rating of 9, United Therapeutics has a strong financial outlook. As mentioned earlier, Graham targets companies that have low P/E ratios and equity-to-asset ratios higher than 0.5. Although the firm has an equity-to-asset ratio that is only higher than 62% of global biotech firms, United Therapeutics has strong interest coverage and returns on invested capital. With an ROIC significantly higher than its WACC, the Delaware-based biotech firm creates value as the company expands.

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Although the company had volatile Piotroski F-scores in the early 2000s, United Therapeutics has had steady F-scores around 7 since 2011. This suggests that the biotech company has a robust business operation and is unlikely to go bankrupt in the short term. Additionally, the company has very strong Altman Z-scores: during the past 10 years, the company’s Z-score seldom decreased below 2.99, suggesting that the company is generally in safe zones.

Currently, United Therapeutics is slightly undervalued based on its Graham number. A valuation method based on EPS and tangible book value per share (“TBVPS”), the Graham number lists the highest price an investor should pay for the stock, according to the intelligent investor. To calculate the fair value of a company, Graham multiplies the product of a firm’s EPS (without NRI) and TBVPS by 22.5 and takes the square root of the entire product. As of March, the company has an EPS (without NRI) of 18.09 and a TBVPS of 37.377; therefore, United Therapeutics’ Graham number is currently $123.34.

Gurus increase positions in high-performing biotech company

As the company’s financials strengthen, many gurus have increased their positions in United Therapeutics during the past quarter. Ray Dalio (Trades, Portfolio) and Lee Ainslie (Trades, Portfolio) increased their United Therapeutics position by 204.79% and 98.01%. Although Dalio increased his portfolio by 0.08% with this transaction, he currently owns the third-highest number of shares in United Therapeutics. Jim Simons (Trades, Portfolio) currently has the highest number of shares in United Therapeutics, 474,578. Joel Greenblatt (Trades, Portfolio), producer of his famous magic formula, has 362,565 shares, good for second place.

GuruFocus users can download guru portfolios from the screeners tab. On this tab, the middle column shows all downloads and add-ins that users can utilize: financial data, guru portfolios and stock PDFs are the first three items on this tab. This feature allows users to download information on guru portfolios to an Excel workbook, which further allows users to view the gurus’ holdings in organized spreadsheets.

See also

Graham’s lost formula of 1976 shares some similarities with Greenblatt’s magic formula. Instead of using earnings yield and returns on capital, Graham uses earnings-to-asset ratios to determine which stocks are undervalued. For more information on Greenblatt’s magic formula, read this article.

For those who are interested in Graham, GuruFocus has a webinar on investing like Ben Graham.

One great feature listed under the “Gurus” tab is Sector Picks. This feature allows users to view all guru trades within a certain sector, for example, health care. Although the default setting is by date, users can sort the list by market cap, impact to portfolio, etc.

Other good features on the “Gurus” tab are the Aggregated Portfolio, Latest Guru Picks and the Scoreboard.

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