The Value in Big Pharma

Bill Miller, the manager of the $21 billion Legg Mason Value Trust Fund, has spent 15 of the last 16 years beating the market by finding value in places that are overlooked by the market. That’s an easy thing to say, but when you manage billions of dollars, you aren’t as nimble as the average $100 million hedge fund. So you have to take a step back, rise above the short-term noise, and look at the long-term trends that most don’t bother with.

In order to find real value in our over-analyzed market, Miller first looks in sectors that haven’t been performing for a while. In this case, “a while” means at least six or seven years — long enough for most investors to have completely forgotten about the sector. This can take a while, and during that time, the stocks within “forgotten sectors” often fall to unreasonably low valuations. Just as valuations can reach absurd heights when investors are enamored with a sector, valuations can reach absurd lows when a sector is forgotten and drifting from lack of attention.

And “drifting” is certainly how you could describe pharmaceutical stocks over the past nine years. After peaking with the market in 2000, the Amex Pharmaceutical Index currently trades at a level it first reached back in 1998:

The components of this index are some of the largest pharmaceutical research and manufacturing companies in the world. They sell their products all over the globe, which means a good portion of their earnings are protected from a continued decline in the dollar. In fact, as the dollar declines, these companies will benefit directly from the more favorable exchange rate when they report their offshore earnings.

Pharma companies are also extremely resilient during times of economic downturns. When patients buy their medications, one of the last things on their minds is whether or not the housing market is going to continue to soften and take us into a recession. If there is a medical need, people go to the pharmacy — end of story.

In addition, there is also a demographic story to this sector. The aging of the Baby Boomer population is projected to increase the demand for everything from so-called “lifestyle” drugs to lifesaving cancer drugs in the coming years. According to Bloomberg, market research firm IMS Health estimates that by 2010 the market for cancer drugs alone will double to $66 billion. And that is likely just the beginning of the coming increase in demand from demographic trends.

Big Pharma’s Long Road to Undervaluation

While the Dow industrials as a group have rallied beyond their 2000 high, one major Dow component remains far below its bull market peak. Big Pharma “Company X” hit a high of $50 in April 1999, but then started a six-year slide that ended at $20 in December 2005 — a 60% decline.

Looking at “Company X’s” stock price alone, you’d be tempted to think their earnings had also been cut in half — but that is hardly the case. Since 1998, sales have almost doubled from $3.49 per share to $6.79 per share in 2006. Earnings have more than tripled from 67 cents per share in 1998 to $2.02 per share in 2006. So the stock decline was accompanied by an enormous decline in valuation. In 1998, its price-to-earnings ratio peaked at 72, but today it trades at just 12 times 12-month trailing earnings.

“Company X”  — which my colleague Brian McAuley and I recently recommended to our Survival Reportreaders — has many important product names out there. But part of the decline in valuation has come as generic manufacturers have taken market share from this company after its patents expire.

However, we all know that stocks almost always make important long-term bottoms when all visible prospects seem dim — and that appears to be the case here. Although “Company X’s” near-term revenue growth prospects are dim, two positive developments are likely going to drive its stock higher from here. First, it has embarked on a streamlining of its operations, which will reduce costs and allow earnings to grow a projected 20% over the next two years. Second, and more important, it’s entering the market with cancer drugs that will compete with traditional biotech companies like Genentech.

In January 2006, the FDA approved one of “Company X’s” products for treatment of kidney and stomach tumors, and is currently testing it for the treatment of breast and lung cancer. Outside of cancer, our Big Pharma pick has much more in the pipeline. In other words, even though competition from generics has taken a bite out of its top-line growth, there is much more in the works that will drive sales down the road.

Regards,
Mike Shedlock ~ “Mish”

July 10, 2007