Wednesday, March 20, 2013

Taking the Pulse On Pharmaceutical Stocks

Two years ago, in March 2011, I headed over to the Merrill Lynch offices here in Boston to hear Gregg Gilbert.

After covering the specialty pharmaceutical stocks for nearly a decade, Gregg had just initiated coverage of the major pharmaceutical group. Gregg had started his career at Merrill following stocks like Pfizer; Merck; and Eli Lilly, so was already familiar with the companies.

His message that day was simple:  Buy these stocks.

His comments were along the lines as follows:

When I stopped covering this group in 2000, all of the stocks were trading a P/E multiples in the high 20's or low 30's, and dividend yields were relatively puny - around 1%. Every meeting I attended was crowded - pharmaceutical stocks were popular with both growth and value managers.

Now, 11 years later, no one likes this group.  Most are convinced that major pharmaceutical companies are dinosaurs, with bloated bureaucracies and meager new product pipelines.  Multiples today are in the single digits, and dividend yields are near 4%.  

But I am telling you now:  This is a tremendous opportunity.  While all of my companies have issues, they are just being priced too cheaply. Buy today, and you will be richly rewarded.

Over the years I have probably attended hundreds of analyst meetings, but only rarely have I heard an analyst speak so forcefully (and rationally) about the stocks he follows.

Yesterday I headed back over to Merrill's offices to hear Gregg again.  Like the meeting two years ago, there were few in attendance, although the poor weather yesterday probably had something to do with the small audience.

But there was no denying that Gregg Gilbert had been right on the money two years ago. 

As the above chart shows, major pharmaceutical stocks have been big winners.  Lilly, for example, is up +60% since March 2011, while the S&P 500 is up +20%.  Lilly also paid investors a 5% dividend yield, which even further increases its outperformance over the the last two years.

Yesterday I reminded Gregg of his prescient call on pharma stocks, and he was understandably pleased that I remembered.

So, I asked, what about now? Are the stocks still attractive?

Gregg characterized his views today as "bullish" as opposed to the "wildly bullish" feelings he had earlier. 

The valuation of most of the stocks (except for Bristol Myers, which trades at premium multiple and that he rates a neutral) are closer to the overall market. Dividend yields remain above the market, yet the gap has narrowed considerably due to the strong relative performance of the stocks.

Unlike other pharmaceutical analysts, Gregg does not base his recommendations solely on new product pipelines.  Drug development is still too uncertain, and success rates relatively low, to buy a stock on new drugs. He likes to find companies with innovative R&D and strong managements trading at cheap valuations.

And most pharmaceutical stocks today still fit the bill.