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As long-duration value investors, we at Smead Capital Management have been very attracted to the conservative accounting, shareholder friendly dividends/buybacks and bright pipeline futures of major pharmaceutical/biotech companies like Merck (NYSE:MRK), Pfizer (NYSE:PFE) and Amgen (NASDAQ:AMGN). Lately, there has been weakness in these shares, and we'd like to review our best theory for recent fears and price weakness, while reviewing the merit of these high quality shares.

One of the more significant deals made by President Obama to get his healthcare plan enacted into law was the one cut with the major pharmaceutical companies. They agreed to give huge price breaks to seniors on prescriptions (fill the donut hole) in hopes of taking less of a beating in the court of public rhetoric and by gaining a huge number of newly insured potential customers. One of the keys to these new customers was the employee mandate. It has been postponed for at least one year out of fear that businesses would postpone hiring or lay off workers. This fear seems to us to be the cause of recent weakness in the prices of major pharmaceutical companies.

To understand the conservative accounting of pharmaceutical companies, you only have to look at their R&D budgets as a percentage of revenue. This R&D investment bears long-term fruit and is expensed, artificially hiding the incredible profitability of these companies. Most companies capitalize and depreciate long-term investments. Despite their ultra-conservative income statements these businesses generate high returns on equity [ROE] without leverage.

R & D as a percent of sales

ROE

MRK

16.7%

20.6%

PFE

13.3%

17.4%

AMGN

19.6%

26.4%

Source: Thomson Reuters: Baseline

Merck pays a 3.6% dividend, recently added $5 billion to an existing buyback authorization and trades around 12.6 times earnings looking forward (P/E 2014). Pfizer pays a 3.4% dividend, boosted its buyback authority last week by $10 billion and trades at around 12.0 P/E forward. Amgen pays a 1.9% dividend, is in a $12 billion stock buyback and has publicly stated that the company would return 60% of adjusted net income to shareholders via dividends and buybacks. It trades at a forward year multiple of 11.8 P/E.

We are very excited about the new products in these companies' pipelines. Anacetrapib, made by Merck, could be the most exciting statin invented to lower bad cholesterol and raise good cholesterol. Early results at the Cleveland Clinic were earth shattering and a huge study is two years toward completion, with 30,000 people being tested. Merck has six drugs ready for approval and 15 in phase three testing. Pfizer has 13 phase three compounds and is especially strong in oncology and pain research. Amgen has 14 compounds in Phase three trials, including five more uses for Prolia/Xgeva, which is already a huge blockbuster drug.

We believe political concerns associated with these companies are a good buying opportunity. First, if Howard Schultz at Starbucks (NASDAQ:SBUX) is correct, it is good business to insure employees. Therefore, we maintain that many employers will wisely insure valuable employees not currently covered. Second, it is our opinion that these securities trade at a big discount to the S&P 500 index and an even bigger discount to the consumer staple companies, which have the most similar economics to the Pharmaceutical companies. Third, as we see it, the dividends are juicy, the free cash flow gushes out of these companies and the stock buybacks are hot and heavy. Lastly, the pipelines could have enormous winners. We believe all of these are attractive considerations for the long-duration common stock investor and portfolio manager.

Disclaimer: The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

Source: Employer Mandate: A Pharma Bump In The Road