The Defensive Value Portfolio’s investment in AstraZeneca PLC has been an almost textbook example of how a strong, market-leading company can survive through tough times, and how patient and brave investors can sometimes get lucky.
3,095.48p on 13/06/2011
4,337p on 05/06/14
|Capital gain (net of fees)|
|Annualised rate of return|
17% per year
When AstraZeneca (NYSE:AZN) was added to the portfolio back in 2011 it was seen as a high risk investment, primarily because of something called the patent cliff (which is as unpleasant as it sounds). Fears over the patent cliff helped to keep the share price below 3,200p for most of the last decade, even as earnings and dividends doubled.
More recently those fears have evaporated to some degree, and the result has been a re-rating of the shares during the portfolio's period of ownership, as you can see below:
But this turn of events wasn't obvious beforehand, and fears over the patent cliff were more than well founded.
Since 2011 AstraZeneca's earnings have more than halved, the dividend has remained flat and the CEO was effectively forced to resign during 2012's Shareholder Spring. So investors were right to gradually reduce AstraZeneca's valuation multiple even as the company grew, because despite that past growth the future looked (and turned out to be) less and less rosy.
As is often the case though, the market missed two things; 1) That companies can adapt, and adapt rapidly when under extreme pressure and 2) that the world is a fickle and random place, and if you wait long enough sometimes good things happen to patient investors. In this case good things came in the form of a takeover bid from Pfizer (NYSE:PFE).
The decision to buy
The UKVI strategy is based around the idea that a high yield, high growth, low risk portfolio can be built around companies that are, to varying degrees, high yield, high growth and low risk. Back in June 2011 AstraZeneca had a dividend yield of 5.3% (the FTSE 100 was yielding 3.1%) and a historic growth rate of 19% which you can see below:
You just don't get a dividend yield of 5.3% on a company growing at 19% a year unless there's trouble ahead; and trouble ahead there was.
But companies in trouble are the bread and butter of value investors, so rather than running the other way, a value investor should try to understand whether or not the problems are sufficient to justify the low share price. If they're not, then the shares may be worth buying.
In this case the problem was the patent cliff, and it was and still is a massive problem for the company.
The patent cliff is where revenues, profits and cash flows fall off a cliff because the patents on one or more highly profitable "blockbuster" drugs expire. This allows "generic" manufacturers to come in and manufacture the same drug and to freely compete on price. As a consequence, margins fall and the drug is no longer a viable product for a research-based company like AstraZeneca, which needs high margins to cover its R&D costs.
Fortunately the expiry date of patents is known well in advance and so companies have ample time to invest in new replacement drugs. Unfortunately, investment in R&D has uncertain returns that are often far off in the future, and so many CEOs are reluctant to reduce profits today for shareholder gain many years from now. Eventually though, the patent cliff will punish companies that under-invest, as it did and continues to do with AstraZeneca.
Having researched the issue, it wasn't clear (at least to me) that the patent cliff was an insurmountable challenge. There appeared to be plenty of research and commentators who felt that, given enough investment and restructuring, AstraZeneca could build a pipeline of new drugs to replace the old. It would take time, but the potential was there.
And so that (very briefly) was the basis on which I selected AstraZeneca for the Defensive Value Portfolio.
It was a leading company with world-class research facilities and access to some of the best brains in the world. It still had massive cash flows that would last for years, giving the company time and a decent chance of beating the patent cliff, as long as the company's management didn't just tinker around the edges.
The decision to hold
Owning AstraZeneca hasn't been a walk in the park. Because of the patent cliff most of the news over the past three years has been bad, with profit warnings, no dividend hikes and a CEO effectively being kicked out by a shareholder revolt.
As a consequence, for the first two years, the investment was mostly underwater, with paper losses of up to 15%. However, these unpleasantries are the price of generating market beating risk adjusted returns; what really matters are the long-term fundamentals of the company, not whether or not the shares are down in any given month.
Eventually, things began to look up. The dividend was maintained and, thanks to the initial 5.3% dividend yield, it helped to provide a decent return despite the lack of capital gains. The new CEO set about restructuring the company and as 2013 progressed some good news began to surface, along with early results from its re-focused R&D efforts.
As investors started to realize (or believe) that perhaps the patent cliff wasn't the end of the world and that AstraZeneca might just survive and even thrive in the future, the share price began to climb. However, the company's results were still going in the opposite direction, as you can see in the chart below.
It's fair to say that the last few years have not been kind to AstraZeneca's headline results:
As usual the stock market is a leading indicator; it is forward looking rather than backward looking. Even as AstraZeneca's results have declined, so the share price has risen, just as in the years before the share price declined as the results got better.
This odd state of affairs simply reflects the fact that investors care, rationally, about the future, and at the moment they are beginning to expect a brighter future now that the company is putting more and more of the patent cliff years behind it.
More recently, things became very interesting and perhaps even a little exciting when Pfizer entered the story.
Pfizer is a research-based pharmaceutical company like AstraZeneca, only bigger. Only a few short weeks ago, Pfizer's board decided that they could make better use of the company's cash pile by acquiring AstraZeneca.
Despite a series of offers around the 5,000p mark, AstraZeneca refused to play ball, on the reasonable grounds that there was no compelling reason for the deal from AstraZeneca's point of view, and that the company had a potentially bright future as a stand-alone venture.
From a shareholder's point of view though, Pfizer's offer and the inevitable reaction of the share price have fundamentally changed the game, and the price to intrinsic value ratio is now far less attractive than it was.
The decision to sell
When AstraZeneca was added to the portfolio at 3,095p, the dividend yield was 5.3%, but the company faced an uncertain future because of the patent cliff. Now that the shares are trading at 4,284p (after the Pfizer-induced rally and subsequent partial relapse after the deal fell through) the dividend yield is down to 4%, and yet the company still faces an uncertain future, although at least now investors can see (and are paying for) the light at the end of the tunnel.
Relative to the rest of the portfolio, AstraZeneca now has a fairly weak combination of yield, value, growth and quality, and so its rank on the UKVI stock screen is one of the lowest.
However, it isn't the lowest ranked holding and I don't think it's a particularly strong sell, either. It still has an above market average yield and I think it still probably has good prospects for future growth. But a sell decision has to be made because there are more compelling opportunities out there.
This is one of the least clear-cut sell decisions I've made for a while. Looking at AstraZeneca and the two companies that have even lower ranks (which I'll call Companies A and B), they all have relatively weak combinations of yield, growth and so on, so why sell AstraZeneca rather than the other two?
If I am completely honest (as I always try to be), then there is simply no way to know, or even have a sensible opinion on, which of those three stocks will do best over the next year or five. It is simply not something that can be known in advance. And so with a decision to be made I find myself rationalizing my decision, rather than making a rational decision, because the rational decision is probably to toss a coin.
Here's my rationalization then:
AstraZeneca is unlikely to grow its dividend for the next few years, because revenues and profits are expected to be suppressed by the patent cliff, and the new pipeline will take years to get up to speed. The current dividend yield is 4%, which is not especially compelling given the odds of no growth in the short and medium-term.
Company A has an even weaker yield at just 2.1%. However, this is a depressed dividend yield after a recent cut, and if the new CEO can enact a turnaround then I think there is a good chance that the share price will increase on the back of any good news. This would result in a larger and more near-term pay-off than is likely from AstraZeneca.
Company B is slightly different again in that it has a yield of 4.6%, which is an attractive proposition in itself. Also, it is expected to grow the dividend solidly in the short-term, and an increase in dividends with an already quite high 4.6% yield may act as a strong catalyst for share price appreciation. Again, this is a nearer-term payoff than AstraZeneca.
Another reason is psychological, in that AstraZeneca has produced solid returns and this is a chance to close the investment with a good result. Both Company A and Company B have so far under-performed, and so I'd rather give them both a little more time to turn things around than sell either one of them now and lock in those weak returns.
And so AstraZeneca has now been sold. Next month, I will be replacing it in the portfolio with another company, which I'll review in the July issue of UK Value Investor.