MSInvestor: Jubak's Journal - When to buy the top of the line
It's a dilemma: how to choose between pricey high-fliers and solid
second-tier players. Here's how I figure it.
By Jim Jubak 7/31/98
Is it better to buy cheap growth or expensive growth? You know what I
mean. Should you buy a high-flying networking stock like Lucent (LU)
that everyone loves or one like Nortel (NT), a company still trying to
break out of the pack? Should you buy shares of Home Depot (HD), a
company that's doing everything right or shares of Lowe's (LOW), a
perennial No. 2? Should you buy Pfizer (PFE), which trades at 60 times
earnings for the past four quarters, or Merck (MRK), trading at 31 times
earnings?
As I look out over the market, in sector after sector I see one or two or
three stocks that have broken away from the solid growth stocks that
make up the middle of the group. I see an incredible difference in price --
measured by price-to-earnings ratio -- between the top one, two or three
names in a sector and the second-tier stocks in the group.
I think I understand why this is happening. This is a market largely
driven upward by liquidity -- the big inflows of cash from mutual funds,
401(k) plans, and a variety of institutional sources. That money has to
go somewhere.
And this is also a market deeply uneasy about earnings growth. Even
stalwarts such as 3M (MMM), Oracle (ORCL), and even Gillette (G) have
stumbled recently, turning in low- or no-growth quarters. A smaller and
smaller number of stocks appear able to deliver double-digit earnings
growth on schedule.
Put the two trends together -- big cash flows and worries about earnings
growth -- and it's only logical that a few growth stocks should trade at
tremendous premiums. (I came at this from a slightly different approach
in my column, "Is That a Stock or a Checking Account?" on July 24.)
But understanding this breakaway by a handful of stocks doesn't tell me
what to do about it. In the drug sector, for example, am I better off
owning the breakaway stocks Pfizer and Warner-Lambert (WLA), or the
middle-of-the-pack companies such as Merck and Bristol-Myers Squibb
(BMY)? I'm not sure that I've got a final answer to that question, but let
me show you how far I've gotten using some pretty standard investing
tools.
The drug sector illustrates the breakaway phenomenon very clearly.
Investor's Finder lists 14 stocks of big drug manufacturers with positive
P/E ratios. After I eliminate Zeneca (ZEN), Astra AB (A) and Pharmacia
Upjohn (PNU), which are at the extreme top or bottom of the scale
because of problems in their basic businesses, I get a very clear
pattern. [I've also eliminated American Home Products (AHP) because
of its scheduled merger with Monsanto (MTC).]
Most of the sector trades at P/E ratios between 45 and 30.
Company
Current P/E Ratio
Schering-Plough (SGP)
45.4
SmithKline Beecham (SBH)
44.2
Eli Lilly (LLY)
38.2
Bristol-Myers Squibb (BMY)
35.2
Glaxo Wellcome (GLX)
33.5
Merck (MRK)
31.2
Abbott Laboratories (ABT)
30.5
Johnson & Johnson (JNJ)
30.2
That's a significant spread, to be sure. But Warner-Lambert and Pfizer
trade at a significant premium (45% and 33%, respectively) to even
Schering-Plough (SGP), otherwise at the high end of the scale. Looking
at these numbers, I think it's fair to say that the big drug sector is
composed of Warner-Lambert, Pfizer,and everyone else.
Company
Current P/E Ratio
Warner-Lambert (WLA)
66.1
Pfizer (PFE)
60.4
What distinguishes the two stocks at the top from the eight in the
second tier? Clearly it's not profitability -- Merck's net profit margin at
19.9% and Bristol-Myers's at 19.6% leave Pfizer (18.2%) behind and
make Warner-Lambert's 11.4% look positively puny. And it's not past
earnings growth. Year-to-year earnings growth at Bristol-Myers (12.5%)
is better than at Warner-Lambert (10.6%) and only slightly lags Pfizer
(14.7%). And Merck (18.9%) badly distances them all.
No, if you want to explain why Pfizer trades for a P/E multiple twice as
high as Merck's, look instead at future growth.
Company
Current
Year
EPS
Growth
Next Year
EPS
Growth
EPS
Growth
Next 5
Years
Warner-Lambert
(WLA)
37.8
30.6
23.2
Pfizer (PFE)
24.3
22.0
19.4
Bristol-Myers Squibb
(BMY)
13.8
13.6
13.3
Merck (MRK)
15.5
15.7
13.8
These figures are all projections, of course. They're analysts' best
guesses on combined sales of existing drugs and others still in the
development pipeline in the current year, next year and over five years.
Still, there's good reason to think that growth at Bristol-Myers and
Merck will be significantly lower than growth at Pfizer and
Warner-Lambert.
Look at the Merck story: The company's biggest sellers are losing
ground, and slews of its products are about to come off patent. Merck's
stars Zocor and Mevacor, two anti-cholesterol drugs that make up about
30% of Merck sales, are losing market share. In January 1997, the two
drugs claimed about 45% of the U.S. market compared with the current
28%. Merck's biggest competition is coming from Warner-Lambert's
Lipitor, which recently was reaping about 35% of all new anti-cholesterol
prescriptions. But Bristol-Myers Pravachol has been winning converts,
too. It now has about 16.5% of the market.
Meanwhile, consider even a partial list of the Merck products set to lose
patent protection: Vasotec (2000), Pepcid (2000), Prilosec (2001) and
Mevacor (2001). When patents expire, other companies are free to make
and sell generic versions of the drugs. Margins go down big.
Merck isn't without replacements for all those products, of course.
Aggrastat, for example, was launched in May to compete with Eli Lilly's
(LLY) Reopro and Schering-Plough's Integrilin for the treatment of
unstable angina. Other new drugs include Maxalt for migraines,
Propecia for hair loss, Singuliar for asthma and Trusopt for glaucoma.
But while promising, none of those drugs are likely to rack up enough
sales to replace a best seller like Zocor. Contrast that to the situation at
Warner-Lambert. Lipitor is already proving itself (sales up 252% in the
second quarter), and it could well be a $6 billion product for the
company. Rezulin sales were up 186% in the second quarter, and
among drugs in the pipeline is Celexa, for depression, which looks as if
it will grow sales rapidly after its September introduction.
You can see the same sort of contrast between Bristol-Myers and
Pfizer. Bristol-Myers' Pravachol is going up against Zocor, and Avapro
(for hypertension) faces tough competition from several drugs including a
very promising newcomer from Astra. Pfizer, on the other hand, has
recently launched several blockbusters -- Viagra being only the most
publicized -- and owns a piece of Zocor and Celebra, the lead drug of a
new generation of products for arthritis pain.
The market has very efficiently discounted the
lower growth rates of Bristol-Myers and Merck into the stock price.
How much should the difference in products and prospects be worth on
the market? I think the best way to start to answer that question is by
seeing exactly how the market is valuing the stocks now.
I've done some simple calculations using Wall Street's own numbers.
First, I used analyst projections for 1999 earnings per share and for 1999
growth rates to calculate a price for each stock at the end of next year.
To get a projected P/E ratio to use in my calculation (share price=P/E
ratio times earnings per share), I adjusted each stock's current P/E ratio
by the percentage decline in growth rate from 1998 to 1999.
So, for example, Warner-Lambert's P/E ratio falls to 51.5 from its current
66 (a 19% decline) because the company's earnings growth is projected
to slow by 19% from year to year. I then calculated the percentage gain
an investor would see from now to December 1999, if Wall Street
projections hold up. I went through the same steps to calculate a
December 2000 price and percentage gain using the projected five-year
earnings growth rate to adjust my projected P/E ratio. I've summarized
the results below.
Company
12/99
P/E
12/99
Price
%
Gain
7/98 to
12/99
12/00
P/E
12/00
Price
% Gain
Warner-Lambert
(WLA)
53.7
100.42
26%
40.6
99.18
-1.23%
Pfizer (PFE)
54.8
141.38
26%
48.3
152.05
7.55%
Bristol-Myers
Squibb (BMY)
34.6
140.48
22%
33.9
156.31
11.27%
Merck (MRK)
31.2
155.69
25%
27.8
160.47
1.77%
Over the short haul, that is, over 1998 and 1999, there's not a significant
difference in the returns that an investor can expect from any of these
stocks if Wall Street estimates are right. The market has very efficiently
discounted the lower growth rates of Bristol-Myers and Merck into the
stock price.
My opinion here is that the consensus is actually underestimating Pfizer, even at a P/E of 60. That's roughly what I expected. Over the short haul, the market does indeed do a pretty good job of pricing stocks in line with the current consensus.
But what if the current consensus about some of these companies is
wrong? Merck could surprise investors by showing more or less growth.
Pfizer could outstrip the pack as its strong set of current offerings, newly
introduced blockbusters, and a promising pipeline produces more
earnings growth than analysts currently believe likely.
Therefore, an investor should really only prefer one of these stocks to
another because he or she disagrees with the current consensus. If,
after looking at new regulations from the Food and Drug Administration,
you conclude that Merck's drug distribution business, Medco, will show
weaker sales and profits than analysts are expecting, then you'd
certainly want to buy another one of these stocks.
The consensus could be wrong in an entirely different way. My analysis
is based on current P/E ratios. It assumes that P/E ratios aren't
irrational reactions to a temporary bubble, but instead a reasonable way
to price earnings growth. I've assumed that the future market -- the one
in 1999 -- will still be willing to pay 40 and 50 times earnings
respectively for Warner-Lambert and Pfizer.
I think that leaves me preferring Merck only if I'm betting on a market-wide decline. Under all other scenarios, I'd rather own Pfizer. As long as this market continues, I'd rather go first class.
So, looking at these stocks as long-term investments, I really have to
answer two questions. First, is the consensus wrong about any specific
company? My opinion here is that the consensus is actually
underestimating Pfizer, even at a P/E of 60. The company not only has
great products and pipelines, but a sales force that other companies
seem eager to harness. I think it's significant, for example, that
Warner-Lambert decided to partner with Pfizer on Lipitor. Pfizer's
acknowledged sales clout should help the company corral a piece of
other blockbuster drugs developed with other companies.
Second, is the consensus overestimating the long-term value of growth?
Look at the gains for the year 2000 in my table. A relatively modest
decline in the multiple for each of these stocks pretty much wipes out
the chance of any profit for the year. If Pfizer's P/E multiple declines to
48 -- in line with the projected earnings growth rate for the stock, and
still a sizable premium to the P/E ratio of 28 carried by average stock in
the current pricey market -- I'm looking at just a 7.5% gain on my
investment that year. It beats a Treasury bond, but not by much.
How do I put these two pieces together? I don't think they point me at
buying a second-tier growth stock. On the consensus, I won't get a
higher return on Merck than on Pfizer. The likelihood that Pfizer will beat
the consensus opinion on the company is higher than the probability
that Merck will beat the consensus, in my opinion. And if the market as
a whole pulls back from its current extreme valuations, both stocks will
suffer. My chart doesn't show Merck beating Pfizer if stocks show a
modest pull back from current valuations. A real correction, of course,
would send Pfizer down far more than Merck.
I think that leaves me preferring Merck only if I'm betting on a
market-wide decline. Under all other scenarios, I'd rather own Pfizer. As
long as this market continues, I'd rather go first class.
Changes to Jubak's Picks
Details
Company Facts
1-yr Chart
Earnings Estimates
Add Lucent Technologies
I'm going to use the current weakness in Lucent Technologies (LU) to
add the stock to Jubak's Picks. In my June 26 column I wrote: "Lucent
is a work in progress that's coming up fast. The company knows the
existing carrier network as well as anyone and has ready access to the
people doing the buying. Recent acquisitions and internally developed
technology have filled some holes in the product line."
Since then the company reported financial results for the quarter that
ended in June -- revenue rose 19% and earnings per share, excluding
the effect of one-time charges, increased to 32 cents share from 17
cents in the year-earlier quarter. The stock has fallen from a 52-week
high of $108.50 a share to close at $89 on July 29. I think this is a good
price to get in. My target price for July 1999 is $113 a share. (Full
disclosure: I own shares of Lucent.)
investor.msn.com
[Thanks to MFahsel, who posted the article at the maerck thread.] |
