Dear fellow investors,
We have been long-term owners of Amgen (AMGN), Merck (MRK) and Pfizer (PFE) among the major pharma/biotech companies. We believe they trade at a ridiculous discount to similar companies in other industries. However, we think we understand why they were underperforming similar stocks and it was a self-inflicted wound. The industry allowed the media to define them as drug companies.
Drugs are something that First Lady Nancy Reagan taught us to say “no” to back in the 1980s. These companies don’t sell drugs, cannabis companies sell drugs. These companies sell medicine and their public relations/advertising people have missed the boat for ten years until just recently. The pandemic has provoked a rethinking of pharma-biotech in our society.
We were watching TV recently and Eli Lilly ran an advertisement where they showed numerous medicines they provide. At the end of the commercial, they introduced their new tag line, Eli Lilly – “A Medicine Company.” This is spot on and important for long-duration common stock investors.
Let’s start with how cheap these stocks are relative to the S&P 500 Index compared to the last 20 years:
When we think about Amgen, we think about Repatha reducing chronic high bad cholesterol, Aimovig eliminating most migraine headaches and Prolia treating osteoporosis. With Merck, we think about curing lung cancer via Keytruda and moving that science forward to use immuno-oncology to cure the other major cancer killers. With Pfizer, we think of the COVID-19 vaccine, Ibrance for oncology and Eliquis for thinning blood to prevent strokes.
Therefore, what is holding these stocks back from getting market multiples or going up while the rest of the market is being priced lower? There are two common criticisms of these companies. First, they charge too much for their products. Second, they must constantly do research to find new products to replace the medicines which lose patent protection.
Please ask folks cured of cancer if immuno-oncology is too expensive. Ask people who at one time suffered 10-12 times each month with migraine headaches if Aimovig is too expensive. Ask people at risk of strokes if Eliquis is over-priced. The answer would be no!
On the new product front, let’s look at the money these companies spend on research and development (R&D). Amgen spends 16.2% of gross revenues, Merck spends 19% and Pfizer spends 21.2%. For these companies this is their long-term lifeblood. From an accounting standpoint, R&D is expensed up front and means that these company’s earnings are among the cleanest in the S&P 500 Index. Netflix depreciates movie and TV show production over eight years, even though their batting average is probably .100. A batting average like that only works if you are a catcher or half your hits are home runs.
Now let’s compare these stocks to Apple (AAPL) and Coca Cola (KO), with similar balance sheets, return on equity, free cash flow yields and a need to constantly come up with new products to perpetuate their success:
As you can see, there is an enormous spread in valuation, even though the challenges are similar. Apple and Coke must respond to improving their products or, in Coke’s case, responding to changing tastes in drinks. There are 100 years of history in the medicine business that Merck and Pfizer can respond and 40 years of history at Amgen. We like these pharma/biotech medicine makers and think they are a great way to avoid stock market failure.
The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.
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