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, MaxKapital (511 clicks)
Long-term horizon, value, growth at reasonable price, capital & stock allocation
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Summary

  • Amgen is a wonderful value opportunity begging for attention from value and dividend growth investors.
  • Celgene is a wonderful growth opportunity, which the growth and risk adjusted PE ratios suggest might be cheaper than Amgen.
  • Both stocks offer a considerable alpha opportunity, with Amgen offering the bigger alpha, with a lower probability off alpha recognition.

It is a big week for the Biotechnology industry and having had a look at Gilead, the only mega-cap (market cap > $100 billion) biotech stock recently, I decided to have a quick look at the large cap biotech names. I screened for large-cap biotech stocks where the key quality indicators were better than the average for the industry. And here is what I got.

(click to enlarge)

Source: Alpha Omega Mathematica

Amgen (NASDAQ:AMGN) is clearly the value leader. Celgene (NASDAQ:CELG) provides an interesting mix of growth and value. Biogen (NASDAQ:BIIB) and Regeneron (NASDAQ:REGN) provide the best growth scores, with Biogen having an advantage over Regeneron on value. And finally Alexion (NASDAQ:ALXN) provides the best momentum.

Value Indicators

(click to enlarge)Source: Alpha Omega Mathematica

I'll rule out Alexion and Regeneron which trade at a PE Ratio based on current year earnings expectations of 34 and 69 respectively. And the multiples based on 2015 earnings estimates are also elevated at 44.72 for Regeneron and 28.29 Alexion. Much of the growth for these two stocks lies more than two years into the future, and I feel future periods of risk aversion will provide a better buy point.

Current year (2014) expectations suggest that Amgen is the cheapest, followed by Celgene and Biogen. I'll rule out Biogen simply because forward five year growth expectations for Biogen are at 19.35% versus 25.15% for Celgene. Thus it is clear that Celgene offers higher growth at a cheaper price than Biogen.

This leaves me with Amgen, which is a value stock versus Celgene, which is a growth stock.

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Source: Reuters Consensus Earnings for AMGN, CELG, BIIB, REGN, ALXN

Whether we look at the trailing twelve month PE, the current year PE, or the forward year PE, we see Amgen is the cheaper of the two. What about growth in the future? Surely that matters too.

In the 1960s a smart gentleman called Jim Slater realized that there is more to the math of the multiple. And he came up with the Price Earnings Growth Ratio [PEG]. This is a lovely ratio to use because it brings the growth differential in as an investment consideration. It is simply the PE Ratio divided by the long-term growth rate expectation.

Amgen has a PEG ratio based on trailing twelve month year earnings of 2.31 versus 1.70 for Celgene. If we look at the current year PE Ratios adjusted for long-term growth differential, we see a current year PEG Ratio of 1.88 for Amgen and 0.79 for Celgene. Thus on a growth adjusted basis it would appear that Celgene provides better value. The problem with growth is that it comes with risk. There is a risk that analyst projections prove wrong: and investors would do well to price that risk.

So let's have a look at growth.

Growth Indicators

(click to enlarge)Source: Alpha Omega Mathematica

Growth expectations over the coming five years for Amgen are meek at 7.63%. Expectations are low, and in my view given a pipeline with sixteen drugs in phase III trials there is scope for a surprise to the upside. There are a further ten drugs in phase II and twenty in phase I trials. Thus there is scope for continuity in growth as the present phase II pipeline progresses to phase III, even while phase III drugs move on to the regulatory and approvals phase.

Growth expectations over the coming five years for Celgene are high at 25.15%. How credible are these growth estimates? In my view, the risk that estimates are too aggressive is relatively low. If you look at Celgene's pipeline you will see a very advanced stage pipeline with several drugs in the phase of regulatory filing and approval and post approval research. And with several drugs in phase I, II and III, there is plenty of depth in the pipeline too.

We know that the PEG Ratio adjusts the PE Ratio for forward growth expectations. How are markets pricing risk?

I thought it might be worth multiplying the PEG Ratio by Beta to develop a P-RAGE ratio: that would be Price/Risk Adjusted Growth & Earnings Ratio. This ratio would simply multiply the PEG ratio by Beta to introduce an element of risk adjustment. I accept that beta and volatility may not be seen by many as a measure of risk. However, for better or for worse, beta pays an important role in investor return expectations: and investor expectations are what I seek to measure.

Value-line reports a beta for Amgen of 0.75 and of 0.95 for Celgene. If we multiply the Current Year PEG ratio by the beta, we get a P-RAGE ratio of 1.41 for Amgen and 0.75 for Celgene. This suggests that Celgene is cheaper when adjusted for growth and risk. The P-RAGE ratio does tell us something interesting about Amgen too: Amgen is cheaper than the broad markets on a risk and growth adjusted basis.

One of the problems with managing growth expectations is that investors tend to extrapolate five-year growth expectations to perpetuity. Thus while a stock may seem cheap relative to another, it may not be cheap in an absolute sense.

We know that Amgen and Celgene are good companies. We know that Amgen traded at a price of $117.02, and Celgene at a price of $143.83 recently. Do there prices represent decent value and a fair price?

Valuation & The Alpha Opportunity

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

Celgene

I will accept consensus estimates of $7.28 as representing sustainable earnings. I accept the analyst long-term growth estimate of 25.15% as a reliable estimate of forward five year growth. I compute a composite very long-term growth rate of 6.86%, based on an assumption that growth will revert to 5% in the sixth year: this level of growth is consistent with, though on the higher side of U.S. nominal GDP growth expectations. This is not to say that it will revert to 5%, it simply suggests that I am unwilling to accept higher growth rates beyond the estimable five-year horizon.

In the long-term I will expect Celgene to earn a return on equity of 20%: a level consistent with industry five year average return on equity reported on Reuters. To grow at a long term rate of 6.86%, the company would need to re-invest 34% (34% * 20% = 6.8%) of earnings. The remaining 66% of earnings represents the adjusted payout ratio: this is the amount shareholders can expect to receive from the company via dividends and buybacks, net of dilution resulting from employee and other issuances, and from growth premiums over the market growth rates.

Assuming a long-term risk free rate of 4.5% and an equity risk premium of 5.75%, an investor in a stock with a beta of 0.95 should demand a return of 9.9625%.

Mathematically, the worth of Celgene is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate]. Thus Celgene would be a decent buy at $165 [106.86% * $7.26 * 66% / (9.9625% - 6.86%)].

This is the price a buy and hold style investor should be prepared to pay. The recent price was near $144, which leaves an opportunity to capture $21 (15% - 21/144) of alpha, after which a long term return expectation of 9.9625% plus growth premiums to market growth rates in the period beyond the coming five years will be delivered.

Amgen

I will accept consensus estimates of $8.16 as representing sustainable earnings. I accept the analyst long-term growth estimate of 7.63% as a reliable estimate of forward five year growth. I compute a composite very long-term growth rate of 5.26%, based on an assumption that growth will revert to 5% in the sixth year: this level of growth is consistent with, though on the higher side of U.S. nominal GDP growth expectations. This is not to say that it will revert to 5%, it simply suggests that I am unwilling to accept higher growth rates beyond the estimable five-year horizon.

In the long-term I will expect Amgen to earn a return on equity of 20%: a level consistent with industry five year average return on equity reported on Reuters. To grow at a long term rate of 5.26%, the company would need to re-invest 26.3% (26.3% * 20% = 5.26%) of earnings. The remaining 73.7% of earnings represents the adjusted payout ratio: this is the amount shareholders can expect to receive from the company via dividends and buybacks, net of dilution resulting from employee and other issuances, and from growth premiums over the market growth rates.

Assuming a long-term risk free rate of 4.5% and an equity risk premium of 5.75%, an investor in a stock with a beta of 0.75 should demand a return of 8.8125%.

Some might scoff at a payout expectation of 73.7%: consider that Amgen has reduced diluted shares outstanding by 42% these past ten years - this amounts to an annualized 5.3% returned via buybacks. This taken together with the dividends paid out adds up to a huge adjusted payout ratio. As time goes by I expect the dividends to rise and the buybacks to fall, until we see a dividend payout ratio of 40% to 50% and a buyback payout of 35% to 25%.

Mathematically, the worth of Amgen is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate]. Thus Amgen would be a decent buy at $178 [105.26% * $8.16 * 73.7% / (8.8125% - 5.26%)].

This is the price a buy and hold style investor should be prepared to pay. The recent price was near $117, which leaves an opportunity to capture $61 (52% - 61/117) of alpha, after which a long term return expectation of 8.8125% plus growth premiums to market growth rates in the period beyond the coming five years will be delivered.

To conclude, Amgen would appeal to a value investor, particularly to income and dividend growth investors. Celgene would appeal to growth investors. As for me, I own neither: I would love to own Amgen as the superior alpha opportunity, despite the risk that the alpha recognition might be slow or absent, unfortunately for now my portfolios equity component is fully allocated.

Source: Amgen Versus Celgene: Value/Growth Face Off