By Robert Brealey
McKesson Corporation (MCK) and Henry Schein (HSIC) are two growth stocks that you can buy and hold without having to worry them about every day. We think of them as neither purely value or growth stocks, but rather stocks that will give you a reasonable return over an extended period of time.
MCK is a $120b pharmaceutical distributor and healthcare information technology provider. HSIC is a $9b dental, medical and animal health supplies distributor and software, e-service and educational service provider.
Over the past 10 years, with the exception of the stock market decline in 2008-2009, both stocks have delivered in excess of 12% annualized, compared to a 4% overall market performance. Since January 2011, both stocks have returned in excess of 19% annualized compared to the overall market of 10%.
Over the period January 2, 2004 to May 3, 2013, though HSIC delivered higher earnings growth of 12.8% annualized compared to 11.5% of MCK, MCK delivered returns of 15.3% annualized compared to 12.5% of HSIC. This is due to a large extent that MCK had a lower P/E ratio of 16.2x in 2004 compared to 21.2x for HSIC, and whereas the P/E of MCK improved to 18.1x, P/E ratio of HSIC declined slightly to 20.5x.
Both companies have had very consistent ROE performance and revenue growth in the past 10 years, a sign of predictability and sustainability in the business. In terms of ROE, both companies have delivered very consistent 15% ROE over the past 10 years, with the exception of a hit in 2005 for MCK. Both ROEs have an uptrend, with MCK's more marked than HSIC's. The earnings decomposition chart below shows that MCK was able to grow its earnings without requiring the same growth rate in book equity by improving its ROE.
Note, however, that MCK has a higher leverage than HSIC, its Debt/EV is 16.6% compared to 6.4% for HSIC, meaning MCK actually has a lower return on assets. In fact, the uplift in ROE for MCK has been partly a result of an increase in Assets/Equity ratio from 3.1x to 4.5x, whereas for HSIC, it has stayed between 1.8x and 2.0x over time. MCK has been offsetting its declining Revenue/Assets ratio by this increase in leverage. Whereas HSIC enjoys a net margin of 4-5%, MCK's net margin is only about 1%, albeit increasing and offsetting its declining Revenue/Assets ratio. Though debt ratios of both companies remain in the safe region (EBITDA/Interest Expense for MCK is 11x and for HSIC 25x), overall, MCK is exposed to higher risk than HSIC for its higher leverage and laser-thin margins.
In terms of revenue growth, both companies have delivered double digit growth for the most part in the past 10 years, with a slowdown in growth rates, steeper for MCK than for HSIC. It appears that MCK, being a larger company, started slowing down in 2006 and only recovered somewhat in 2012, whereas HSIC only hit speed bumps in 2009-2010 and 2013, with quick recoveries. Whereas the average revenue growth rate of MCK between 2000 and 2004 was 17.4% compared to 14.3% of HSIC, it has slowed down to 4.8% between 2008 and 2012, compared to 8.7% for HSIC.
Close to 95% of MCK's business is Pharmaceutical distribution. HSIC is more diversified, with over 50% dental, 25% animal health, 17% pharmaceutical and 3% technology. Animal Health is an interesting segment for HSIC and continues to become more important because it has been growing at double digit rates.
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However, incorporating current valuations, analysts are more bullish on HSIC than for MCK. For MCK, 12 analysts rate it a buy, 4 hold and none sell, whereas for HSIC, 4 rate a buy, 11 hold and 1 sell.
I see both as stocks that you can buy and hold for the long term. Actually, I prefer HSIC slightly over MCK given its more bullish growth outlook. Valuations matter less for stocks that you want to buy and hold over the long run, so long as they are not too ridiculous. The room for improvement in P/E ratios is limited, unlike what MCK enjoyed for the past 10 years compared to HSIC.
My model for HSIC assumes a 10% earnings growth for the next 5 years, 13% RONE, a future P/E of 18x and a beta of 0.8. Using these assumptions, I expect HSIC's value to be around $100, about 12% above its current price, and if you buy and hold today, you can expect returns greater than 9% annualized. Current and near-term earnings account for over 96% of current share price, which means this is a very safe investment. The upside is if HSIC can maintain a higher P/E ratio closer to 20x, which it has done so historically, in which case fair value is closer to $110 and future returns 11%.
For MCK, my model assumes a 7% earnings growth for the next 5 years, 13% RONE, a future P/E of 16.5x and a beta of 0.9. I have chosen a lower earnings growth rate for MCK because it is wholly dependent on pharmaceutical segment, whereas HSIC is supported by a faster growing animal health segment. I have also chosen a higher beta, given its higher leverage. With these assumptions, I expect MCK's value to be around $120, about 11% higher than its current price, and if you buy and hold today, you can expect 9% returns. Current and near-term earnings account for over 96% of current share price, which means this is also a safe investment.
Buy MCK and HSIC if you don't want to buy and sell at exactly the right timing, nor worry about occasional dips in stock prices. We believe this is what many non-professional investors want, because they don't have time or want to look at financial news on a daily basis. We believe this is a significant departure from mainstream investment thinking, which often cares more about capturing temporal mispricings in the market rather than picking investments that actually create shareholder value. Yes, money can be made by being cleverer or faster than the market, but there is a also a way for those who just want to buy and hold.
Additional disclosure: This article was written by Robert Brealey, one of our contributors. Neither CandidMarkets nor Robert Brealey received compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.