In 1999, Warren Buffett was asked by a shareholder if he made a mistake by not buying the stocks of leading pharmaceutical companies when they were selling at depressed prices in 1993 under the specter of increased government regulation. Buffett’s response was that he had “blown it” by not doing so and that he would “do it in a second” if given a chance to buy a basket of pharmaceuticals at a “below-market” multiple. (1)
His reasoning was simple. Leading pharmaceutical companies are good businesses and as such they don’t deserve to trade at a depressed multiple. He also said that rather than trying to pick an individual pharmaceutical company in which to invest, he would buy a basket of leading pharmaceutical stocks because of the difficulty in picking winners in that industry.
Currently many leading pharmaceutical stocks are once again selling at depressed multiples, and some highly regarded investors have taken notice and made substantial purchases. According to the latest data at Gurufocus.com, a site that tracks the investments of prominent value investors and hedge funds, twenty-nine of the “gurus” they track have an investment in Pfizer, with three of the investors – David Einhorn, Irving Kahn and Donald Yacktman – having more than 5% of their long equity investments in the stock.
Several prominent investors have recently taken positions in other leading pharmaceutical companies including Astrazeneca (AZN), Bristol-Meters Squibb (BMY), GlaxoSmithKline (GSK), Johnson & Johnson (JNJ), Eli Lill (LLY), Merck (MRK), Novartis (NVS), and Sanofi-Aventis (SNY).
Regarding Pfizer, David Einhorn made the case in his second quarter 2010 letter that investors were overreacting to a difficult macro-economic outlook in Europe and concerns about Pfizer’s pipeline. He thought that investors would eventually pay more than the sub 7x earnings at which it was then trading.
Here is David Yacktman’s take on Pfizer from his just-released 2Q, 2010 letter to shareholders.
“Pfizer is the largest pharmaceutical company in the world. Pharmaceuticals are a cost effective way to treat an aging population. However, Pfizer is the least predictable business of the five in this list (PepsiCo, News Corporation, Coca-Cola, Clorox) because it is fighting patent expirations, pricing controls, and greater competition than consumer or subscriber based businesses.
To compensate for the less predictable future, the stock trades at less than 7 times free cash flow. We believe the company should generate more than $10 per share in free cash flow over the next 5 years. Given the significant residual value of the business at that point, we see lots of safety in the current price of slightly more than $14 per share. There can be material upside if the company has even modest success with drugs in its pipeline, finds accretive acquisitions, successfully expands its generic business, or grows its biologic drug presence.”
Value investor Vitaly Katsenelson, CFA argues that Pfizer is worth $19-20 per shares even if sales of Lipitor drop 90% from $12 billion to $1.2 billion and its massive R&D effort of $11 billion does not produce a single new drug.
Similar concerns about patent expirations and pipelines weigh on the other leading pharmaceutical companies as well.
The difference between now and 1993 is that currently the market is concerned about the large numbers of blockbuster drugs coming off patent, whereas in 1993 it was the political risk of increased regulation. Investors will have to decide if Buffett’s central argument – that a basket of leading pharmaceutical companies does not deserve to sell at a depressed multiple – still holds in today’s environment.
Here’s the current earnings multiples on a number of leading pharmaceutical companies based on consensus earnings estimates for 2010 and 2011. Prices are as of the close on August 4, 2010. Berkshire Hathaway has positions in GlaxoSmithKline, Johnson & Johnson and Sanofi Aventis according to its most recently filed 13F-HR.
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(1) Outstanding Investor Digest, December 31, 1999, p. 60.
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