THE SEARCH FOR VALUE

One way to select a winning investment in Big Pharma is to troll the discount wrack. As a concept, this approach really isn’t much different from shopping at Marshall’s or Ross Dress for Less. We are NOT Kmart shoppers; we aren’t looking for garbage stocks at garbage prices. We are looking for known brand names that are slightly out of fashion, lightly dinged, or just out of favor at the moment.

This general methodology of choosing investments is often referred to as VALUE INVESTING. The search for diamonds in the rough has inspired many dozens of investment guides and newsletters. That’s because it works. Over the long period from 1973 to 2014, a “Value Portfolio” of common stocks would have delivered an average return of 16.5% annually, vrs. The S&P 500’s average return of 10.3%. That kind of differential can lead to a mind boggling difference in total return over time…..in fact, the value portfolio would have delivered 1000% more total return over 40 years than the standard S&P 500. (19).

How do we quantify a “low price,” for a stock? Is a stock listed at $5 a better deal than a stock listed at $10? Not exactly. Maybe a stock is worth $5, and the other $10. The key that we are looking for is to take advantage of inefficiencies in the market so that we can buy a $10 stock for just $5.

In 1949, an author and Columbia University Professor named Benjamin Graham wrote a tome that has become the Bible of value investors everywhere. The book was simply entitled “The Intelligent Investor.” One of the most influential concepts that Graham teaches in the book is the analogy of “Mr. Market.”

…   Imagine that in some private business you own a small share that cost you $1000. One of your partners, named Mr, Market, is               very obliging indeed. Every day he tells you what he thinks your interest is worth and he offers either to buy you out, or sell you               an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and               prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the                 value he proposes seems to you a little short of silly.

     If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1000 investment in the enterprise? Only in the case that you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position…..basically, price fluctuations have only one significant meaning for a true investor. They provide him with an opportunity to buy wisely when prices fall sharply……”

     Our goal is to obtain $10 worth of value by paying $5 when a stock has fallen out of favor due to the vagaries and illogical gyrations of the market.

Before we continue, let me take just a few sentences to implore, beseech, and strongly advise that you make efforts to become FINANCIALLY LITERATE. If you are reading this blog, then you clearly have a serious interest in educating yourself about finance. Now take the next step; learn some basic accounting. This is advice coming from a perennial “C” student in math, who reserved a special spot on his bedroom wall for banging his head during those frustrating days of algebra, geometry, and trigonometry. Math never was my strong point, but I made it through those basic classes because I had a strong desire to be considered an educated person in society. But I had an even stronger desire to understand the business world around me, so I taught myself just enough basic accounting to evaluate my investments. As vulnerable as you would be in life if you couldn’t read and write at least on a rudimentary level, you are just as vulnerable if you can’t understand accounting, which is the core language of business.

While you may have made enough time to read this blog, maybe you just barely had that time. You could be saying to yourself “That ship has sailed. I don’t have time to go back to school to take accounting classes, or do homework, or get an MBA.” Don’t let the financial media fool you into thinking that so much effort is required to learn basic accounting!!! You don’t need to learn so much that you could be a CPA or the Chief Financial Officer of Exxon Mobile. But I do strongly suggest that you learn just enough to read the INCOME STATEMENT, BALANCE SHEET, AND CASH FLOW STATEMENT of the major public companies that you seek to invest in. As an investor, you are protected by laws that require that publicly traded companies disclose all relevant numbers in those three accounting statements. What good would all the disclosure do you if the language of business looks like Greek to you?

We are living in the golden era of self education. The internet is overflowing with all kinds of accounting courses you can take at your pace, at the level you want, and at the very modest price you want (the price for such courses ranges from $500 to free). If that’s too intimidating for you, and you feel like a dummy, well, there is a book entitled “Accounting for Dummies.” There is actually a “dummies” website where they will give you basic financial literacy pointers for free!!! Even the Federal Government provides educational opportunities; the website SEC.GOV has a section entitled, “A Beginner’s Guide to Financial Statements.” If you want to learn how to seek value so that you can get Your Piece of the Action, this is a great place to start.

Whatever level of financial literacy you currently possess, the place to begin the process of bargain hunting is by examining a company’s PRICE TO EARNINGS RATIO (PE for short). This is usually a number between 3 and 40 that indicates how many years of earnings you would have to pony up to buy the company. This is why you will sometimes hear Wall Street big shots through out the jargon “I wouldn’t buy at this multiple.” Or “That multiple seems rich to me…” Because if a company makes $3,000,000 per year, and the current market value of the company is $9,000,000, then the stock is currently trading at a “multiple” of 3.

You may have noticed from Professor Graham’s quotation above, he wants the individual shareholder to imagine himself as if he owned the whole business. That makes it simpler to provide a real world example that any investor could understand (the last thing the Pirates in Neckties want…).

Let’s say for example, that you owned a convenience store. Every year, the convenience store makes $100,000. Somebody walks into the store and offers you $400,000 dollars for the store. That means that the offer valued your store at a Price to Earnings ratio of 4. You think it over carefully, and decide that you prefer the steady cash flow, year in, year out, of owning the store, and you turn down the offer.

A few years later, your son goes to Harvard Business School, gets an MBA, works in Goldman Sachs for a few years, and acquires a lot of high flying Wall Street pals. They come and take a look at your store, they love the concept, and they also think you should sell the store. But this time, they pitch you the idea of selling the store to the public. This means that there could be hundreds, or thousands of people who each own a tiny percentage of the store, you will be legally obligated to disclose certain detailed financial information on a regular basis, and literally anyone can buy or sell shares of the store on Etrade. This time your son’s banker friends tell you that if you FLOAT the shares on the public markets, they can sell the store for $1,000,000, even though it only makes the same $100,000 a year that it made a few years back when you were offered $400,000 for a regular old fashioned transaction. This would mean that you are being promised a Price to Earnings Ratio of 10 instead of 4!!!! This time, you might very well take the deal.

In just a few paragraphs, we have uncovered why the titans of Wall Street are infamous for private lear jets and baronial estates in the Hamptons. In the example above, nothing really changed about your store except marketing. For some reason that no one really knows, private companies that sell all at once often sell for much less than public companies whose ownership is chopped into thousands (or millions) of bite sized chunks.

The only way an investor would understand this would be by examining and comparing price to earning ratios.

So, in reference to our earliest questions in this chapter, the way we determine what is worth $5, and what is worth $10, is by COMPARING price to earnings ratios between companies. For the more advanced investor, there are many other ratios that can also be analyzed, but PE ratios are the most commonly referred to and the most common ratio to compare.

To begin your journey towards value investing, write down the names of the most common Big Pharma stocks that you can think of (Pfizer, Eli Lilly, Merck, AstraZeneca, Roche, Sanofi-Aventis, Takeda, Novo Nordisk, etc, etc.). Then Google the names, or use your online brokerage, or call your broker, and find the PE number for each company. ( The numbers could be between 3 and 40, but most common will be between 8 and 20). Then rank the companies from the highest PE ratios to the lowest PE ratios. If you rank 10 companies this way, then take a highlighter and mark the four with the LOWEST numbers. These will be the four Big Pharma companies that Mr. Market thinks the least of at this moment. These will be the companies that you will put time and effort into researching.

There is some risk in bargain shopping Big Pharma stocks. If you isolated four stocks with low PE Ratios, two probably have low PE ratios for a good reason. Just like some clothing at Marshall’s is on deep discount for a reason, same with stocks. However, remember, as long as you stay within the realm of Big Pharma ($4 billion dollar market capitalization or more, with more safety coming with larger sizes……$10 billion and up becoming very safe), it is unlikely that these companies will perish from existence. Remember, not one Big Pharma company went broke during the Great Recession. The most likely negative outcome is simply stagnation, meaning the stock price doesn’t go up much over the next 10 years, or goes up less than certain peers.

If you are able and willing to invest the time and energy to do the research, odds are you can pick a winner. Remember in my previous Pfizer example? Even with Pfizer producing almost no new drugs for a decade, you still would have doubled your money over 10 years. Learn about the drugs that each company has on the market, and learn about the markets for each disease state. Learn about the new drug Pipeline for each company. Learn about the management of the company. Practice reading their financial statements until you have the “ahha!” moment and realize that you can understand them. You are smarter than you think; you can pick a winner.