Biovail: When Stock Screening Alone Isn't Enough

Stock screening is a valuable tool for investing. Investors can either set their requirements and then pick up all the stocks that meet that criteria, thus investing by the statistics, or they can use the process to identify only a couple of names. In this latter case, it is particularly important to do your homework. Indications of easing economic growth sent us looking for stocks that are relatively shielded from the dynamics of business cycles. What we found, however, is a good reminder of the importance of performing company research after using stock screening.

Government statistics showed the US economy expanded at a seasonally adjusted annual rate of 2.9 percent in the second quarter. Although this is faster than the previously reported estimate, it is slightly slower than what many economists expected, according to a Reuters poll, indicating that the Federal Reserve's series of interest-rate hikes since June 2004 is working to ease growth. Given the typical lag of between six and 18 months for the economy to feel the full effects of a change in interest rates, there are at least another 75 basis points of hikes working their way through the system. In our search for companies that are relatively shielded from economic fluctuations, we found Canadian biotech company Biovail Corp. (BVF) on the Reuters Select Strong Operating Margins stock screen.

We began with the list of the 734 companies that recently appeared on at least one Reuters Select stock screen. We then focused on the companies in the consumer non-cyclical sector. We also included certain companies from the healthcare sector - those in the pharmaceutical industries. This left us with a list of 66 names. (Click here to download an Excel spreadsheet comparing these companies.)

To narrow the list further, we focused on performance and valuation criteria, starting with a measure of management effectiveness. We looked for companies with superior long-term performance, where the five-year average for return on investment [ROI] surpassed their respective industry averages. This took our list down to 25 companies.

Very high rates are typically unsustainable over long periods. So, we wanted some indication that management's effectiveness remains relatively better than the industry norm. For this, we filtered for companies with ROI performance at least 10 percent above the industry mean in the trailing 12-month [TTM] span, as well. This resulted in a list of 19 companies.

As indicated below, Biovail has generated ROI figures that considerably eclipse the industry averages over both the TTM and five-year time frames. The company also leads its peers in the biotechnology & drugs industry on the basis of other measures of managerial effectiveness, including return on assets [ROA] and return on equity [ROE] over similar periods.

Learn about Management Effectiveness

Then we turned our attention to valuation. It would be easy enough to simply require that we now want companies with price to earnings (P/E) ratios below the industry averages. But, since we have so far highlighted companies with superior levels of net income given available capital, we also have to be willing to accept some premium built into the valuation. As such, we filtered for P/E ratios that are no more than 10 percent above the industry standard. This reduced the list to only 12 names.

Biovail's P/E ratio currently prices the company at a significant discount to the industry average. In fact, Biovail's shares are cheap relative to the industry norm on the basis of many traditional valuation metrics.

Learn about Valuation Ratios

Next, we want some indication that the company is relatively more efficient and better able to profit from its production and operations given its cost structure. For this, we filter for companies that have a five-year average operating profit margin that is superior to the industry average. This reduced the list to eight names.

We also want companies that are improving. We then looked for firms where the TTM operating margin is better than the industry norm and also superior to the company's own five-year average. Yet, it is important to keep in mind that solid economic growth has enabled many industries to improve their profitability over the last year or so. Since we don't want a company that is simply improving because the industry is improving, we also sorted for companies where the magnitude of their relative advantage over their peers has widened in the TTM span from the five-year time frame. This resulted in a list of only five names, with Biovail at the top.

Biovail's relatively superior operating margins also enabled it to register on the screen for Strong Operating Margins, which requires that a company's operating margin stand above the industry average over both the TTM and five-year periods. The screen also requires that the firm's TTM reading must be at least 25 percent wider than its five-year average. As indicated below, Biovail's other profit margins also eclipse the industry standards.

Learn about Profit Margin Ratios

Although Biovail landed on the screen for Strong Operating Margins, risks exist that could pressure growth and margins down the road - specifically, competition related to a generic formulation of its key product Wellbutrin. In fact, part of the reason why the stock is priced so cheaply stems from this concern.

Shares of Biovail have shed more than 35 percent of their value in the last six months, including more than 22 percent in the last four weeks alone amid worries a competitor might launch a generic version of Wellbutrin. Demand has been solid for the drug; sales jumped more than 60 percent in the second quarter, driving bottom-line growth. Between the falling share price and rising earnings, the company's P/E dropped to well below the industry mean.

Biovail is taking legal action to protect its drug, which accounts for about half of its revenue, but the outcome is uncertain. Although Biovail's numbers, based on historical performance, are solid enough to enable it to land on a stock screen, a little digging illuminates potential difficulties down the road that are not captured by the screens, thus serving as a nice reminder that stock screening is only part of the security-selection process and that investors need to do their homework when dealing with portfolios that only have a few names in them.

At the time of publication, Erik Dellith did not directly own puts or calls or shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.