Merck Could Continue Gains As A Defensive Pick, With Growth On Top Of That

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About: Merck & Co Inc. (MRK)
by: TradeCircle
Summary

Merck has been one of the best-performing large caps since volatility returned in October.

I argue this is the results of prudent strategy and wise use of resources from back when the stock was underperforming.

Keytruda keeps getting new approvals. Merck has extremely low leverage, and is generally seen as a safe stock, which could help it attract more capital if volatility intensifies.

Even if the stock falls amid wider market stresses, it should fall less than its peers and much less than more economically sensitive stocks.

Can Merck (MRK) help stabilize your portfolio in the current market stress? Let’s take a look. The pharma giant has been doing spectacularly well since volatility returned, and has barely felt the ongoing market lurches. Look at a 1-year chart of Merck and you’d never guess that the broader market has been teetering violently.

Healthcare stocks in general continue to be a significant bright spot amid the gathering atmosphere of dread surrounding equities. Unfortunately, the positive returns for biotechnology stocks proper have been few and far between, as this industry has been the biggest laggard in the Healthcare sector, while the pharmaceutical industry has outperformed.

Stocks like Merck are generally considered defensive, as they have less exposure to economic cycles unlike financials, energy, and basic materials. Unlike other companies though that are mostly bought as names well-recognized and then ignored by the vast majority of traders, the healthcare industry has a captive audience with minimal alternatives, which makes its revenues more stable.

Within the pharmaceutical industry for 2018 particularly, Merck has had a very strong year, outshining its main competitors. Over the past five years, Merck has outperformed not only the S&P 500 but also its main rivals: Pfizer (PFE), Roche (OTCQX:RHHBY), Johnson & Johnson (JNJ), Sanofi (SNY), and GlaxoSmithKline (GSK).

(Chart Source: Yahoo Finance)

It should be noted that the domestic firms (Pfizer, Merck, and Johnson & Johnson) have kept up with the S&P 500 over the past five years, while Sanofi, GSK, and Roche started underperforming in 2014 and have failed to keep up. This somewhat underscores how strong the domestic US pharmaceutical market has been over the past five years. The strong economy up to now has been a tide that has lifted all boats, but the favorable operating environments within the US could also be another reason why the US-domiciled firms have done better. With a strong dollar, revenue exposures have been one of the excuses companies have used when missing earnings, but each of these companies receives at least a third of its revenue from US sales, which negates that excuse.

Comparing these firms to the equal-weighted biotechnology and pharmaceutical indexes paints a better picture of performance. By utilizing equal-weighted indexes, we neutralize for size, which displays a more complete picture of these industries. For this exercise, the SPDR Biotech ETF (XBI) was used as a proxy for the Biotechnology Index and the SPDR S&P Pharmaceuticals ETF (XPH) was used as a proxy for the Pharmaceuticals Index.

(Chart Source: Yahoo Finance)

What can be visually seen from these two charts is that biotechnology is a lot more volatile than the pharmaceutical index, but the pharmaceutical index has underperformed domestic companies. These indexes are equal-weighted, so we have a chance to see how small caps can distort the returns. For the biotechnology index, this shows up in the increased volatility with more significant price movements. On the other hand, for pharmaceutical firms, it shows up in the underperformance of the index in comparison to the largest companies.

Small-cap pharmaceuticals have struggled over the past five years, and their return profile has been sub-par in comparison to the larger-cap companies. The issue with small-cap companies in these two industries is that they usually do not have a reasonably diverse drug pipeline, which creates binary outcomes.

Out of all of these companies, Merck stands tall, but this is also a company that underperformed the S&P 500 by 2800 basis points in 2017, so some would say we have been seeing a mean reversion this past year. True, however, a lot of the recent price run has come after its blockbuster drug Keytruda hit a milestone in mid-January last year, so if the current strength is building off of recent approvals, the climb can continue. Last year, Merck had two approvals for Keytruda because it cuts lung cancer deaths in half and works on clients who cannot tolerate chemo. The significance of this news took a while to be noticed by investors, because at that time, the emerging markets were starting to fall into bear markets. Over the past six months though, aggressive, growth-oriented investors have taken notice and piled into the stock, while valuation-sensitive investors have fled. Pfizer has gotten some attention from aggressive growth investors along with some who prefer the stock for its dividend yield.

Financially, Merck has had some tough times over the past couple of years. Net income steadily declined from 2015 until 2018, while net operating cash flow and free cash flow decreased during this time. Despite the hardship, the company did not cut its dividend, but rather, doubled down and purchased a significant amount of investments and shares, which probably helped bolster the stock price and avoid a collapse when equity markets started to break.

Merck is not a perfect company, but management seems to not be afraid of taking relatively short-term losses in order to clean up the balance sheet, which is exactly what it did and is partly why it is outperforming now. The company has done this a couple of times over the past ten years, and it has worked out well. This past year, Merck has aggressively paid down debt and has boasted a record number of patents, with the highest number of products in pre-registration at the end of 2017. Keytruda has another hurdle to jump in February, and its usage could possibly be expanded to kidney cancer, which would be a direct threat to Bristol-Myers Squibb’s (BMY) Opdivo.

Conclusion

2019 is shaping up to be a tough year based on the headwinds that currently stand in our way. Macroeconomic headwinds have become more apparent towards investors, while political risk has increased. The World Bank has downgraded global growth, making companies with higher sustainable growth rates harder to find. During uncertain times, companies with dependable cash flows and strong balance sheets are favored by investors, all the more so Merck, whose Keytruda revenues look set to continue expanding regardless of the global economy. Its balance sheet is very strong with only 10.5% leverage by debt-to-market cap, having paid down nearly $4.3 billion in debt over the last two years.

If the volatility continues in global markets, it is possible that Merck will not completely escape it. The stock could decline from here if a bear market is truly underway, just from oblique selling pressures. However, given its strengths, dividend, financial stability, the number of new drugs in the registration phase, and the continued expansion of Keytruda approvals, it will most likely decline much less than its peers in healthcare and certainly in biotech. And if the bear market is aborted, then its growth could really impress to the upside. Either way, Merck is a good pick for 2019, whichever way the markets go.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MRK over 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.