Testing the Efficient Market Hypothesis on CVS Caremark

The Efficient Market Hypothesis (EMH) asserts that stock prices appropriately incorporate relevant information. As such, it isn't possible to generate market beating returns because the current price reflects available information. While it's not possible to completely disprove this theory (EMH theorists attribute the success of Warren Buffett and other value investors we've looked at here to random chance), there are examples which make this very difficult to believe. Consider CVS Caremark (CVS), a provider of pharmaceutical services.

Despite economic hardships, most people will not go without their required medication. As such, one would expect this business to be stable even at the worst of times. A look at the operating margins for CVS over the last business cycle reveals this line of thought to be correct:

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We can see from the chart above that CVS has maintained margins through downturns, as one would expect considering its industry. The stock price, however, tells a different tale. The stock has dropped 30% in just the last few months, despite very little change in the earnings or earnings outlook for this business.

If the market was right when the price was $43 then how can it be correct now at $27, when little has changed. Examples like this certainly offer doubt as to whether the market always appropriately values stocks. While this doesn't neccessarily mean CVS is undervalued now (as perhaps it was just overvalued before), it does suggest there are profit opportunities for those who are able to take advantage of Mr. Market's mood swings.

Disclosure: None

Comments

[Dan Jacome:]

you are on the right path, but you need to do look at why sentiment on CVS has eroded...one reason is that contrary to myth, people are cutting back a bit on Rx trends - either by splitting tabs or delaying utilization..the only silver lining is generics - with co pays of $5 vs copays of $25 for branded, its pushing profits up nicely and drug retailers are leveraging that

Jan 05 11:31 AM

[CynicalOnCVS:]

When you look at CVS, you need to look at CVS Caremark. There are two sides to this company and events that impact one side will impact the other. I see potential problems with the company. First, the more alternatives available to consumers for purchasing their prescriptions, the more downward pressure on the price of those drugs. Wal-Mart will continue to expand their formulary and we have a new president who would like to open our borders with Canada for prescription drugs. Could these alternatives drive the PBM into extinction? In hard times, with companies closely monitoring their expenses, isn't it possible that with enough alternatives available, companies will simply decide to drop prescription benefits to their employees? If you know your employees can go to Wal-Mart or Canada to buy their prescriptions, why would you provide that benefit and pay a PBM to manage the benefit? I really don't have the answer, but I think time will tell. Prescription drug coverage is such a hot button issue and anything is possible.

Jan 09 06:18 PM