Monday, August 22, 2011

A Prescription for Profiting on Drug Stocks

When this Barron's article was first published, back in early July, most of the large drug stocks -- like most other sectors at that time -- were selling at higher prices.

So that means the recent market sell off has created a slightly larger margin of safety on some of the larger drug stocks.

Some of these businesses are doing a better job than others moving beyond traditional patented pharmaceuticals and developing franchises around consumer-products, generics, and vaccines.

In the article industry analyst Tim Anderson (Sanford Bernstein) made projections out to 2015 and 2020 for nine U.S. and European drug companies. Not many analyst project so far out into the future.

His conclusion?

GlaxoSmithKline (GSK), Novartis (NVS), Pfizer (PFE), Merck (MRK), Sanofi (SNY), and Roche (RHHBY) are best positioned long-term.

A table at the bottom of the article summarizes current and projected future price to earnings, and dividend yield -- among other things. Keep in mind most of the stocks are now selling at lower prices so appropriate adjustments need to be made.

Over the long run, these businesses have generally produced above average return on capital yet some difficult to answer questions remain:

Can the pipelines of these businesses be replenished at a high return on capital going forward as older drugs come off patent?

Will the consumer-products, generics, and vaccines businesses eventually add some predictability and robustness to these franchises?

Those questions will not be answered anytime soon so I think a larger margin of safety for most of these companies is warranted.

The valuations on some of these seem to mostly reflect the patent cliff and other concerns. Since these businesses are often at the mercy of unfavorable headlines , I generally prefer to buy the best of these when the headlines are at their worst. The underlying problems (related to those headlines) may in fact be serious, but even the best businesses runs into trouble from time to time. Is the problem fixable at a reasonable cost? That's what will matter in the long run. Well, that and whether it was bought at an attractive price. Ultimately, I still think the diversified platform of Johnson & Johnson (JNJ) -- even with its well-publicized recent missteps -- is worth the valuation premium.

The recent market sell off did not hit large pharmaceuticals nearly as much as some other sectors.

Still, the patent headwinds, weak R&D productivity, and the market sell off has created a chance to buy shares in large drug companies at what seems a decent discount to intrinsic value.

Even though I think better capital appreciation opportunities exist elsewhere, many of these businesses produce above average dividend yields that can easily be covered with free cash flow.

Yet, for most of these above average capital appreciation is only there if bought at a bigger discount than what is now available.

Adam

Long JNJ, GSK, PFE and SNY
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