Merck: Time to Buy a Rewarding, Long-Term Investment?

Includes: MRK, PFE
by: John Tobey, CFA

A rising market lifts all stocks, right? Well, not exactly. Even in a bull market, some stocks lag. Shareholders experience dismay, even distrust, from being left in the dust. That’s the situation with Merck (NYSE:MRK).

Weak performers today can become strong ones tomorrow, and the turnabout returns are usually quite good. So, let’s look at Merck and see what's ailing the stock.

Merck’s Current Characteristics

On the surface, Merck is interesting. Its price/earnings ratio, based on 2011 estimated earnings, is only 8.6 (= 11.6% earnings yield). The dividend yield is an attractive 4.6%.

However, Merck’s favorable measures are partly because the stock has performed poorly during the market’s recent rise.

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Pfizer Follows Wall Street’s Advice - Merck Follows Its Own
Pfizer’s (NYSE:PFE) stock has been rising nicely with its new focus on earnings management and a decision to cut expenses, particularly its drug research. It will then “invest” the money by buying back stock to keep earnings up. Wall Street likes the news. It makes for a nice, short-term trade.
Meanwhile, Merck announced it would stick to its long-term business focus. CEO Kenneth Frazier said, “Investing in our growth is in the best long-term interest of the company.” Also, “We are committed to innovation as a strategy, and we believe that over the long-term, it will pay off.”
He really surprised Wall Street by saying that Merck would no longer be making long-term, multi-year earnings projections. In other words, Merck's leadership is pursuing a corporate strategy that it believes will succeed in the future – but that the measure of success (earnings) cannot be known in advance. Pretty heady stuff, but appropriate for an industry undergoing challenges.
Financial Times Provides a Contrarian Buy Signal
Note: Financial Times, like The New York Times, has well-written investment pieces. However, they share a weakness. They each have difficulty envisioning change. Therefore, when a downtrend has had a long run, they tend to provide thoughtful explanations of what happened that conclude with no hope – just more of the same. If we can spot an unseen benefit, then we have a contrarian opportunity.
In “Drug companies have lost far more than their health” (Financial Times/, the author paints a dismal picture of the pharmaceutical industry.
Pfizer is lauded for attempting to “meet its earnings growth targets by cutting its research budget, correctly observing that its (research department’s) productivity has declined.” Conversely, Merck “has lowered (short-term) earnings projections to maintain research spending.”
His conclusion? “The market’s immediate verdict was that Pfizer was right.”
His view of the future? “When an industry model is broken, the best business strategy may be to manage its decline.” That pessimistic description is inappropriate for an industry that incorporates technological developments. It also is a perfect example of a contrarian message.
Pharmaceuticals - Still a Promising Product
We read every day about new research results. We know that something will come from areas like nanotechnology and DNA knowledge. Moreover, we know that pharmaceuticals, in spite of high price complaints, are usually (always?) the lowest cost method of preventing or treating ailments.
The industry model isn’t broken. It’s different, and Merck is working to adapt while preserving the strengths that have made it a great pharmaceutical company.
So ... it’s time to think that the outlook for the pharmaceutical industry has become too pessimistic. It’s a time to bet on research and innovation – not to think that the industry is fully matured and that companies should rely on financial management. Merck, with its resources and commitment, seems to be in a good position to benefit. With its stock offering a 4.6% yield, we can afford to be patient. MRK could turn out to be a rewarding, long-term investment.
Disclosure: I am long MRK.