Pharmaceuticals Pregnant and Overdue

 |  Includes: ABT, AMGN, BMY, JNJ, MRK, MYL, PFE
by: Smead Capital Management

As the Father of five adult children and one grandchild, I have a little second hand knowledge about pregnancy. It was a long, slow painful experience with a huge reward at the end.

There are not many sure things in common stock investing, but one that all academic studies prove is that valuation matters over time in the stock market. Fama and French showed that constant rededication to the lowest price-to-book ratio stocks yields above average results. Scott Bauman and David Dreman proved the same for low price-to-earnings ratios. Frances Nicholson's study validates the low P/E advantage and how the advantage grows as the holding period is lengthened without portfolio rebalancing.

Why don't more portfolio managers and investors trust one of the surest forms of long-term advantage in the stock market? The answer is the time frame and crowd psychology. Valuation oriented investing is very much like being pregnant. You get to know whether and not when. You have to be pregnant and overdue while babies are being born all around you. You have to go through the same difficult process each time while everyone around you doubts the theory confirmed by the academic studies.

Let me give you a few examples. In 1998-99, Richard Rainwater spent millions on unwanted low P/E and/or low price-to-book oil stocks. The tech bubble raged all around him. In May of 2008, he sold at massive profits. In 1991-92, Warren Buffett bought a huge position in Wells Fargo (NYSE:WFC) in the aftermath of the Banking debacle of the late 1980's and early 1990's. Biotechs were hotter than a pistol back then. Wells Fargo's low price-to-book ratio teed him up for huge long term profits, but things looked ugly in the early years of pregnancy.

Each time that a major industry falls into the lowest P/E quintile there are major and "well known" reasons for the disfavor. Each time you have to resist coveting the current popular baby deliveries and sit in your well chosen pregnancy in an uncomfortable position with no due date guarantee.

This is very lonely. John Maynard Keynes was a great investor as well as an economist. He ran the equity investments for Cambridge and King's Colleges from the late 1920's to 1940's. He also ran money for two London-based insurance companies. He said, "When I can persuade the Board of my Insurance Company to buy a share, that, I am learning from experience, is the right moment for selling it."

What major industry fills the low P/E quintile in the S & P 500 Index today? The Pharmaceutical industry hasn't been this far out of favor since 1981-82. We are pregnant with these fine companies (MRK, ABT, JNJ, MYL, AMGN, BMY and PFE) while babies are being born in Emerging Markets, Heavy Industrials, Basic Materials and Commodities. We believe the academic studies and sit patiently waiting for overdue babies to enter the world through labor over the next three to five years.

Disclosure: I am long WFC, MRK, ABT, JNJ, MYL, AMGN, BMY, PFE.