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, MaxKapital (540 clicks)
Long-term horizon, value, growth at reasonable price, capital & stock allocation
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Summary

  • Gilead has declined 20% from its recent 52-week high. This decline provides an opportunity to buy growth at a reasonable price.
  • The current drug portfolio supports current three-year forward earnings growth expectations at an annualized rate of over 25%.
  • The late stage pipeline provides a high margin of safety and potential for growth premiums to market growth over the coming five years.

The Growth versus Value Debate

Since 2007, growth has outperformed value. This chart shows how SPDR S&P 500 ETF (NYSEARCA:SPY), SPDR S&P 500 Growth ETF (NYSEARCA:SPYG), and SPDR S&P 500 Value ETF (NYSEARCA:SPYV) have performed relative to each other. And this picture is broadly consistent with one-year, two-year, and five-year relative performance.

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Source: Nasdaq Interactive Charts

However, when we look at the past three-month or one-month relative performance, we see value starting to outperform. The chart below displays one-month relative performance, because the past month has done the greatest damage to growth stocks.

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Source: Nasdaq Interactive Charts

Consensus from the Wizards of Wall Street suggests that over the very long term, value outperforms growth. And at the present time, it appears that growth has outperformed value for a reasonably long time. Does this mean that we are about to see a change to one where value outperforms?

I look at things slightly differently. Cheap stocks may outperform expensive stocks over the long term. Yet a fast growing stock trading at a cheap value is likely to deliver the highest outperformance. There is absolutely no reason why a fast-growing stock, with a higher multiple, should not be considered cheaper than a slow-growing company, with a lower multiple.

Buying Growth When It Represents Value

In this post, I will look at Gilead (NASDAQ:GILD). As a result of substantial price declines in recent times, Gilead trades at a P/E ratio of near 40 times trailing twelve-month earnings. Compare this with Johnson & Johnson (NYSE:JNJ), trading at a multiple of near 20 times trailing twelve-month earnings. But the fact that Johnson & Johnson has a trailing twelve-month P/E of half of the one for Gilead does not indicate that the former is cheap, relative to the latter.

The chart below indicates that over the past five years Johnson & Johnson saw prices increase by 84.44%, compared with a price increase of 209% at Gilead. That is the price, what about performance? Gilead's trailing twelve months revenue increased 99.74% versus an increase of 13.96% at Johnson & Johnson. Trailing twelve-month earnings increased 9.12% at Johnson & Johnson, versus an increase of 67.10% at Gilead. Clearly, Gilead's superior growth justifies at least some of the excess of price gains versus Johnson & Johnson. This is history, what should we expect in the future?

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This chart displays expectations over the coming years. Gilead earnings are expected to grow from $1.819 now to $8.22 over the coming three fiscal years. Johnson & Johnson is expected to grow from $4.982 now, to $7.05 in the coming three fiscal years. This suggests that if analyst estimates are correct, Gilead is trading at a multiple of 8.34 times three-year forward diluted earnings, while Johnson & Johnson is trading at a multiple of 13.82 times, three-year forward diluted earnings. Perhaps Gilead is the value stock here.

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But How Creditable Are Analyst Expectations?

Are we willing to accept growth risk and future cheap value, versus a relatively cheap Johnson & Johnson today?

In the most recent earnings release, for the antiviral sales we saw:

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And for cardiovascular product sales we saw:

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Complara was approved in August 2011. It is relatively young in the market, continues to display solid growth, and is still short of potential revenue of $2 billion expected by 2017. Stribild is also relatively young in the market and continues to display robust growth. Stribild is expected to grow annual revenues to near $3.2 billion by 2017. Finally, we have Sovaldi, which was approved in December 2013. Sovaldi is a baby in the market. And it is off to a good start, with analysts expecting the drug to rack up sales of over $5 billion during 2014. This drug set off fear in the stock, as politicians questioned the price at $1,000 per pill. And there was also more fear caused by slowing prescription growth. Nonetheless, analysts expect growth to continue until sales peak at $9 billion per year, even with slow prescription growth.

In my view, the existing portfolio of drugs has sufficient potential to justify the growth estimated by analysts. Of course there are risks. Risks of new competing drugs are ever-present, the risk of political intervention lowering profitability is another. But then there is no investing without risk, and in the case of Gilead, a robust pipeline does provide a margin of safety.

You can view Gilead's pipeline here. There are ten prospects in Phase III development, including three in HIV/AIDS, three in Oncology, and two each in liver and cardiovascular. From amongst these, Cobicistat has been approved in the EU in the HIV/AIDS group, with the drugs in the process of U.S. regulatory submission. In the liver disease group, a fixed-dose combination of ledipasvir and sofosbuvir is in the process of U.S. regulatory submission. And in oncology, Idelalisib is in the process of EU and U.S. regulatory submission for Indolent non-Hodgkin's Lymphoma and Chronic Lymphocytic Leukemia.

The oncology submissions are most promising. In a press release of January 2014, Gilead says: "FDA granted idelalisib a Breakthrough Therapy designation for relapsed chronic lymphocytic leukemia (CLL). The FDA grants Breakthrough Therapy designation to drug candidates that may offer major advances in treatment over existing options."

Thus in my view, growth risk is low and analyst estimates in the case of Gilead are credible and have a sufficient margin of safety as a consequence of a strong advanced stage pipeline of drugs.

How do different market participants view Gilead?

A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better. The model output for Gilead can be viewed here (or you can view the nicer beta version here). There will be some differences between the model output you will see on the website, versus the information presented below - this is because I run the algorithm for a coverage universe of all stocks with a market capitalization of over $100 million, while the site runs it for a coverage universe of all stocks with a market capitalization of over $10 million.

This quantitative analysis of investor behavior suggests that the market is neutral on Gilead. Strong growth expectations together with high quality return and profits make the stock attractive. Ownership quality and value are neutral. Momentum is ugly. A strong credible growth expectation, when valued well, coupled with ugly momentum, often offers a very nice entry opportunity.

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Source: MaxKapital Archives

More specifically, Gilead is most attractive to growth investors, particularly those allocating stocks at a sector level. It is also attractive to balanced investors allocating capital at sector level. My observation is that a stock has the best bottom opportunity when at least one of the Momentum stock selectors shifts to sell.

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Source: MaxKapital Archives

How do different market participants view Pfizer, Merck, or Johnson & Johnson?

Johnson & Johnson

The markets view Johnson & Johnson positively at present. It is backed by very attractive value, attractive return and profit quality and momentum. Ownership quality remains neutral and growth expectations are on the low side.

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Source: MaxKapital Archives

Johnson & Johnson is attractive to very attractive to all stock selection and capital allocation styles.

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Source: MaxKapital Archives

Pfizer (NYSE:PFE)

Pfizer is perceived as neutral, but verging at buy. The stock is well valued, has good quality return and profits, and neutral ownership quality. Momentum and growth are on the weak side.

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Source: MaxKapital Archives

The stock is attractive to all kinds of stock selectors allocating money at sector level, and to value investors allocating capital in a manner, which allows no sector or industry bias. All else are neutral.

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Source: MaxKapital Archives

Merck (NYSE:MRK)

Merck like Pfizer is also neutral. Good value and momentum, with neutral ownership quality characterize the stock. Subdued growth expectations and a poor year on earnings quality are a drag, the latter is expected to change in 2014.

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Source: MaxKapital Archives

All kinds of stock selection and capital allocation styles are neutral on Merck, except for growth investors seeking to allocate capital at Industry level, who are negative on the stock.

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Source: MaxKapital Archives

Why Look at Gilead Now & Is it well valued?

Gilead returns value through growth rates, which are at a substantial premium to market growth rates. My personal investments in healthcare are in Merck, Pfizer and Johnson & Johnson . The kind of money I represent is very focused on income, and perhaps the focus on dividend would have been different some years ago. I would like to add Gilead, despite the pain of having to forgo income. But despite being well valued at present, it would need to be much cheaper. The reason is simple: I have a large tax cost associated with an exit from my current healthcare positions, and so the new stock selected would have to be valued at a level where that tax cost is covered.

There are many reasons to buy Gilead. Firstly, Gilead is a mega cap stock. This gives it a defensive character, which appeals to me when I perceive the markets are expensive. Secondly, the stock has a low beta. This adds to the defensive characteristics and protects downside during weak markets. Thirdly, Gilead as recently priced includes potential alpha. Alpha is the difference between actual returns and risk adjusted returns an investor should expect from a stock. When a low beta stock includes potential alpha, downside protection is provided by the low beta, while upside total return potential is not compromised, because we earn returns from alpha in addition to the lower upside beta driven gains associated with low beta stocks. Finally, in my view, the U.S. economy is getting ready to shift from mid-cycle to late-cycle conditions. And during late-cycle, stocks in the healthcare sector tend to outperform. You can have a look at this information from Fidelity here to understand their take on sectors and the business cycle. One note of caution: I find reading the business cycle is getting increasingly difficult with globalization - for instance today I think U.S. is exhibiting classic signals of a move towards late-cycle conditions. However, the global business cycle is quite out of sync, with the U.S. business cycle. And since many U.S. companies are very influenced by the global business cycle, it is more difficult to figure how U.S. sectors will behave. For example, technology is expected to underperform in late cycle conditions. But if Europe, other developed markets, or emerging markets, shift into mid-cycle conditions, which is a time when technology typically outperforms, U.S. companies in the technology sector could well outperform.

The above noted defensive characteristics are offset by volatility arising as a result on a shift of investor emphasis from growth to value, and as a result of the absence of defensive characteristics from a dividend.

Analyst price expectations

Recently Gilead traded at $68.55. From Yahoo Finance we know that twenty-five analysts expect an average price target of $99.20 (median $99.00), with a high target of $132 and a low target of $75. This is a pretty wide dispersion in expectations. The wide dispersion in high and low price estimates suggests that the risk is somewhat high. So far the bears have it. And that might just present a good opportunity to buy growth at a reasonable price.

Valuation

We might believe that Gilead is attractive. But thus far its attractiveness has been viewed relative to other stocks in its sector, industry, or the coverage universe. We do not know whether the stock is priced to deliver a long-term return in-line with our expectations.

Mathematically, the worth of Gilead is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].

What is our long-term return expectation for a stock with a beta of 0.85, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? This beta of 0.85 differs from the beta you will see in other places because it is based on a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge toward one. You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Gilead, we should be targeting a long-term return of 9.3875%. Is the stock priced to deliver that return?

Earnings tend to be volatile from year-to-year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. Since Gilead has a pipeline and performance to support earnings and forward growth expectations, I will work with $3.83 (analyst estimates for 2014) as a reasonable estimate of sustainable earnings.

The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends, buybacks net of dilution, or growth at premium to market growth rates. I expect Gilead will pay out approximately 40% of earnings dividends, buybacks, net of dilution, or growth at premium to market growth rates over the long term. This 40% estimated adjusted payout ratio could be substantially higher if Gilead is able to continue its return on equity at 20% levels. A return on incremental equity of 20%, with a very long-term growth expectation of 9%, would suggest that 45% (9%/20%) of earnings must be re-invested to generate the 9% target growth, with the remaining 55% (the adjusted payout ratio) being available to shareholders.

If we use a very long-term growth expectation of 7%, Gilead is worth $68.55. Gilead Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 107% * $3.83 * 40% / (9.3875%-7%) = $68.55. At this price it is likely that an investor with a return expectation of 9.3875% will be satisfied.

The growth estimate implied by the current market price of 7% is low. In my view, Gilead can be expected to grow at a faster rate. A very long-term growth rate of 9% can be expected. If we work with a credible 29% three-year growth rate, and assume that after three years, the growth rate will fall back to an 8% growth rate, in-line with potential real Global GDP growth of 4.2%, and global inflation of 3.8% for the next forty-seven years, we arrive at a composite very long term fifty-year growth rate of 9.16%. By computing this composite fifty-year growth rate we are not suggesting that growth will decline to 8% in the fourth year: we are simply implying that we are willing to pay a premium for the next three years' growth, after which as long standing shareholders, we would expect to participate fully in growth rates which run at a premium to market growth rates.

The spread between the 7% growth priced by markets, and a 9% growth expectation, is 2%: this represents potential long-term alpha. Alpha is the difference between actual returns and the risk adjusted return expectation. Since we have a risk adjusted return expectation of 9.3875% for Gilead, a long-term investor targeting a risk adjusted return of 9.3875% will end up earning a return of 11.3875%.

Now 2% alpha might seem like a small number, but remember, with the magic of compounding, over the course of a 50-year working life, it is a very significant advantage. It often pays to buy good companies trading at a good price.

An investor with a shorter time horizon might do quite well too. A price target of $132 implies confidence in long-term earnings growth rising to 8.13% from 7% at present. And an 8.13% long-term growth rate expectation remains well below my expectations of 9%. Gilead Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 108.13% * $3.83 * 40% / (9.3875%-8.13%) = $132.

The formula above helps to compute a fair value for a stock. It is simple, and you can use it to calculate a value based on your expectations, as opposed to mine. But if you do so, be cautious.

If you alter your risk free rate assumptions, you will need to evaluate how that will impact market return expectations and the equity risk premium. You will also need to think about how the risk free rates will impact long-term growth. If you alter the adjusted pay-out assumptions, think about how that might impact the growth assumption and the capital structure. For instance, higher growth may signal a need for fresh equity or debt. And if the capital structure changes, so will beta. When you alter growth assumptions, think about how it might change the operational mix, and the impact that might have on the stock's beta and stock return expectations.

There is a high degree of inter-connectivity between beta, growth, adjusted pay-out ratios, risk free rates, and market and stock return expectations. And reading the inter-connectivity wrong will result in an answer that ranges from absurd to obscene: this model comes with warts. To avoid falling into this trap, here are some ideas, which I hope will help.

1. Since valuation is about what you are willing to pay for a stock, perhaps the most important consideration is the growth risk premium: that is long-term return expectation minus long-term growth rate. The question to ask yourself is that if you expect a stock to grow at a certain rate, how much over and above that growth would you want by way of a stock return expectation, to compensate you for the risk that the long-term growth rate might not be in line with your expectations. This spread will be low for a fast growing stock, where there is great confidence in forward growth expectations, and higher for stocks where the confidence in growth is low. In the very-long term, the growth risk premium has tended toward 4.5% for the market.

2. When you look at sustainable earnings for a growth stock, you need to look at where you expect earnings to be a few years down the road. And then discount that number to its present value using your stock return expectations to obtain today's sustainable earnings

3. When you look at long-term growth rates, remember it is not the next years' growth or the next five years' growth you are looking for. You are looking for a composite long-term growth rate expected over the life of the company. This will be made up of foreseeable growth rates for some years, reversion to market growth rates, and finally a terminal growth rate. The terminal growth rate used by many is the risk free rate. I tend to use the very long-term market growth rates, since if the terminal growth rate is below market growth rates, I as an investor have the option to exit and enter the broad market. The life-expectancy of a typical Fortune 500 company is 40 to 50 years: you can read more about this here. So we can consider using a five-year forward rate, and then assume growth shall revert to being in-line with market growth expectations for the following 45 years. What this signals is that I'm willing to pay a premium for currently foreseeable growth expectations, but after that period, I expect to share fully in the reward of growth over market growth rates. On excel you can calculate a composite growth rate for a company growing at 15% per year for five years, followed by growth at 8% for the following 45 years as 8.68% [=POWER(1/1*115%^5*108%^45,1/50)-1].

4. Test your adjusted payout expectations. Take your growth rate and divide it by 1 minus the payout ratio. The result will estimate the return on equity implied in the model for the company. Review the return on equity to see if it is broadly consistent with the return on equity for the industry over the long term. If it is high, review the return on equity in the context of the leverage employed by the company. A levered company will have a higher return on equity, and so a high return on equity for a company may be perfectly justifiable in some circumstances. However, higher than industry leverage implies higher financial risk and this implies a higher beta, and a higher market return expectation. If you see a low beta with higher than industry leverage, you may want to compute a bottom up beta for the company, instead of one generated using regression analysis.

Source: The Hunt For Hidden Value: Gilead Gilded In Gold