I don't often mingle with other investors, but I imagine the standard question at a cocktail party of investors would not be "What do you do?" but rather "What do you buy?" In these imaginary cocktail parties, should you attend them frequently, you directly hear the changes in investment styles throughout the years. For example, one decade ago, cliques of "biotech investors" and "dividend investors" would stand on the opposite sides of the room, having nothing to do with each other; today, however, you would not be surprised to meet a "biotech dividend investor."
The entire biotech investment environment was changed by one company: Amgen (NASDAQ:AMGN). In a world where "biotech" seriously meant "high risk, high growth" to investors, AMGN stepped forward and began offering dividends, bringing in a new class of biotech investors: conservative, dividend income-seekers. But AMGN entails another type of risk: the risk of being first.
On Friday, AMGN experienced a significant gap down:
This is not a common sight for the average dividend portfolio, but it is frequently seen in the portfolios of biotech investors. Wild swings, volatility spikes, speculation, and overreaction are nothing new if you're holding a portfolio of biotech companies.
Biotech Dividend Safety: An Oxymoron?
This brings up an important question for AMGN dividend investors: How safe, exactly, is the dividend of a stock that can soar due to a single successful clinical trial and crash due to a single drug failing to live up to hype? Whereas the safest dividend companies act like casinos, taking in consistent but small amounts of profits, biotech companies such as AMGN act like gamblers aiming to survive at the table long enough to hit the jackpot. But AMGN is aiming to change the name of the game by dedicating itself and its investor relations to the dividend, which is a major step away from the traditional billboard of generic biotech stock XYZ: the pipeline.
The options market reaction, posted above, shows that AMGN is still acting like a biotech stock, dividends be damned. The fact that option buying is at this level shows that speculators care little for the AMGN dividend. It is unlikely that options are preferred to the stock because of the dividend being low, as 3% is a decent yield for a stock with much growth potential; more likely is the presence of many short-term traders targeting AMGN, forcing volatility into a stock that many dividend investors would prefer to see stable.
This could be good or bad for dividend investors. On the one hand, you have frequent buying opportunities. On the other hand, stocks targeted by traders tend to see violent overreactions to the news and attempts to "push the stock" through assumed levels of support.
Greed vs. Fear
The temptation of growth plus dividends is counterbalanced by the fear of sudden drawdowns and the urge to constantly check AMGN's recent movements. For many AMGN investors, there is a significant time expense in reading the news and attempting to understand the findings such as that just reported if you lack the background in biotechnology. Thus another question AMGN investors should be asking themselves is whether the time and stress of holding such a wildcard of a dividend stock is worth it.
Part of the answer calls us to stop treating AMGN like a special snowflake and look at the damn numbers. After all, a dividend is a dividend: AMGN pays its dividend the same way as does Mattel (NASDAQ:MAT) or Westpac (NYSE:WBK). Thus, the standard analysis still holds and should be employed by anyone eyeing the current gap in AMGN as a buying opportunity.
One of my preferred methods of analysis for dividend stocks is to run my own model of discounted cash flow pricing. Dividend stocks have proved to me that this method of valuation is particularly reliable, most likely because of the significant overlap between the metrics used to construct this model and the metrics used to determine dividend safety. In addition, discounted cash flow pricing trends - that is, plotting the estimated price against the true price over time - can show buy and sell signals that are represented by inflections in either the stock price (e.g., a rally or selloff caused by overreacting market participants) or in the fundamentals (e.g., gradual transitions away from growing free cash flows), allowing current investors to find buying times superior to the random dollar-cost averaging plan and allowing new investors to find a reliable entry point for their first acquisition of a position in the dividend-payer.
Let's begin with valuation. In my experience of running dividend analyses, most dividend stocks with strong track records for raising/sustaining their dividends or with growth opportunities (AMGN being the latter) are overpriced to some extent by their future cash flow valuations. AMGN is no exception:
For AMGN and its ilk, I prefer to, first, use my own discounted cash flow model that better accounts for the company's growth and cash flow, and second look at the trend of the discounted cash flow pricing instead of a mere point in time. Doing so gives a better picture of the company and, in my experience, is more accurate in predicting future stock price. We begin by smoothing out these values, as biotech stocks are prone to significant jumps and falls in its fundamentals; consider AMGN's cash returned on invested capital, which we use to represent the company's growth rate (CROIC):
This is a trend hard to describe. The value right now looks average, but the trend tells us that CROIC has been growing for five years. Smoothing the values with a running mean gives a better idea of where AMGN's growth is headed and from where:
Clearly, AMGN is not what it used to be in growth, but that is expected of a company transitioning from a growth stage into a "dividend stage." We are looking for steady, consistent growth, not huge growth spurts like the one in the early 2000s. The graph above is telling us that AMGN's recent turnaround in growth is finally looking stable; we will account for this in the discounted cash flow model.
We repeat the process for the somewhat less erratic free cash flow history:
The smoothed picture looks even better, implying almost exponential cash growth:
My discounted cash flow model, based on the above metrics, as well as others, has some interesting implications:
Not only does the model claim AMGN to have been undervalued until late 2014, but it also almost exactly pinpoints the time of the pullback, at which point AMGN would have been considered overpriced. The model shows AMGN to have been fairly valued for most of 2016 and now, for the first time, gives a clear buy signal, pointing to a valuation of over $200.
On to $200: Two Steps Forward, One Step Back
The stock indeed headed toward the direction of our $200 price target but pulled back upon the Repatha data. With Repatha not being included in the small set of drugs that makes up the company's revenue, bad news about the trial should have no impact on the above valuation, which is purely fundamental. This implies that, at least for dividend investors, the pullback is a buying opportunity. The model above relies not on Repatha being a success and only relies on AMGN continuing its growth as would any other public company that makes its profits from sales (i.e., not financial companies).
With an implication of a 19% upside over the coming year, the model above should alleviate the concerns of AMGN investors who originally bought in for the dividend but now find themselves worrying almost daily about how many investors will sell their shares or - perish the thought - even short the stock. If you're buying for the dividend, evaluate by the dividend. We will do exactly that in part 2 of our analysis, but before I go let me leave you with a chart to ponder:
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions 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.