2 Drug Companies That Belong In Your Portfolio

Includes: AZN, NVS
by: Nicholas Jacobs

Despite the anemic economy, stocks had a good year in 2012: the S&P500 index, for example, is closing the year more than 10% up. Don't expect this to continue in 2013, as the economy slides into recession. It's time to adopt a defensive approach: concentrate on reliable income streams, regard any stock with a high P/E multiple very skeptically, and look for the big long-term trends rather than short-term technical factors.

One driver of long-term trends will be ObamaCare. Although it is already being phased in, many important provisions will not take effect until 2014. By bringing health care to more people, ObamaCare will increase overall medical expenditure. The main impact will be in four areas:

  • Health insurers

  • Health care providers (HMOs, hospitals, etc)

  • Pharmaceutical companies

  • Medical appliance manufacturers

Any benefit to health insurers is highly uncertain and likely to be small, because we can expect them to be more closely regulated. Switzerland has had a health-care model somewhat similar to ObamaCare for about 15 years, and controls insurance costs by requiring insurance companies to show they are making zero profit out of the basic compulsory health insurance. Insurance companies still want to participate in the market even though they only break even, because they get customers to whom they can market add-on insurance and other insurance products; but they get no direct profit from the business that corresponds to ObamaCare. Expect similar regulation here.

We can expect most health care providers to be increasingly subject to regulation, too.

While drug companies will probably also see increased government regulation in the future, it is less likely to crimp their profits, because of wide recognition that a lot of drug-company revenue goes into development of new drugs. So this sector should benefit from ObamaCare. To some extent this is true of medical appliance manufacturers - companies like Intuitive Surgical (NASDAQ:ISRG) do significant research and development - but the total R&D expenditure of pharmaceutical companies is much greater and has a higher political profile.

This is not to suggest that all pharma companies will be immune to adverse impact from regulation. Just last week, drug manufacturer Questcor (QCOR) made headlines in the New York Times for increasing the price of an old drug, which some patients are dependent on, from $50/vial to $28,000/vial. Questcor does not develop new drugs; its blockbuster was developed in the 1950s by a different company. According to the NYT article, its hugely increased revenue goes largely to lavish bonuses for salespeople and big salaries to top executives. Questcor is practically begging to have its profits regulated out of existence, and there is a real risk that politicians will do just that.

We will avoid that risk by focusing on pharma companies which have a track record of new-drug development.

In the generally adverse environment which I foresee for the stock market in 2013, we also have to take into account the traditional metrics of value: P/E (don't pay too much for a stock), dividends (make sure you get paid), and the dividend ratio (make sure the dividend is sustainable).

In the following table, P/E and yield are based on trailing earnings. Financial data from Yahoo finance; drug pipeline data from the Citeline 2012 Pharma R&D Annual Review. Other columns calculated from Yahoo Finance data and the Citeline data. I use the 6-year dividend growth, not the 5-year growth, because 2008 was the year the financial crash started and would give too rosy a picture if used as a base year. Using 2007 as the base year means we see the dividend growth over a period that included a financial crash.

Company Symbol P/E Yield Payout ratio Total pipeline 2012 Pipeline / Revenue 6-year Dividend Growth
AstraZeneca AZN 9.6 3.80% 57% 144 4.3 62.9%
Bristol-Myers Squibb BMY 28.6 4.40% 126% 146 6.9 21.4%
Glaxo Smithkline GSK 13.6 5.40% 73% 257 6.1 20.2%
Johnson & Johnson JNJ 22.76 3.50% 80% 142 2.2 48.1%
Eli Lilly LLY 13.19 4.00% 53% 125 5.2 21.7%
Merck & Co MRK 18.47 4.20% 78% 223 4.6 11.2%
Novartis NVS 17.73 3.90% 70% 218 4.3 127.6%
Pfizer PFE 19.49 3.90% 100% 225 3.4 -24.1%
Sanofi SNY 15.96 3.60% 58% 178 3.9 53.4%

The payout ratio, which is the dividend paid out as a percentage of total income, is important because if it is too high the dividend will probably not be sustainable.

The drug-pipeline data from Citeline is not usable as a criterion as it stands, because a bigger company needs more drugs in its pipeline to sustain its larger revenue. We allow for this by dividing the total number of drugs in the development pipeline by the company's revenue (in $billions). The resulting number - pipeline/revenue - is a crude figure of merit for the pipeline size in relation to the company size.

Putting all this together, we shall select for:

  • P/E less than 20 (Don't pay too much)

  • 6-year dividend growth more than 25% (Keep up with inflation)

  • Current dividend yield more than 3.5% (Dividends will be our main return)

  • Payout ratio less than 75% (Otherwise dividends may not be sustainable)

  • Drug pipeline per billion of revenue more than 4 (Future profitability)

Applying these filters leaves only AstraZeneca (NYSE:AZN) and Novartis (NYSE:NVS). These currently pay dividends of 3.8% and 3.9% respectively, which is about 5 times the yield you'd get on a 5-year treasury bond. Of course, the income stream is not a secure as the interest on a T-Bond. But, unlike the interest on a T-Bond, you can expect the dividends from these companies to increase in line with, or faster than, inflation. Given our expectation of trends in health-care expenditure, continued profitability of these companies seems assured, and they have a track record of returning increasing value to shareholders. They deserve a place in your portfolio.

Disclosure: I am long NVS. I may initiate a long position in AZN within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.