Seeking Alpha

Play Defense With Gilead Sciences

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About: Gilead Sciences, Inc. (GILD)
by: Oyat
Oyat
Investment advisor, long-term horizon, asset allocation, tailored equity products
Summary

Gilead is more a mature pharmaceutical company than a risky biotech, and provides investors with a defensive business not heavily linked to the aging economic cycle.

Gilead’s quality and valuation make it a strong value investment, providing protection in a market that is twice as expensive and puts a high premium on growth versus value currently.

Gilead’s strong balance sheet and cash flow mean no reason to worry in a recession when funding dries up, while such an event would offer more attractive prices for acquisitions.

In a market with low expected returns, Gilead’s dividend yield and free growth potential make it attractive to own now.

Stock markets continue to run higher and perpetuate the longest bull market in history. Escalating stock prices in 2019 largely pushed valuations up as profit growth was essentially non-existent, with growth-related stocks once again trouncing value names. It’s anybody’s guess how long current market dynamics will last, but it may very well be prudent for investors to build more defensive exposure into their portfolios today, both for protection against a downturn and as a strategy for relative out-performance. But defense at a good price is exceedingly difficult to find in today’s market. Companies in historically defensive sectors such as consumer staples trade at breath-taking valuations. Value options are often in tricky industries going through transformational changes such as retail. Companies with strong underlying businesses that trade at depressed multiples are exceedingly rare. But there are some exceptions for investors looking hard enough.

Gilead Sciences (GILD) is such an exception and provides investors with an excellent option to play defense while maintaining realistic potential for superior performance. Gilead’s base pharmaceutical business is predictable and largely detached from the cycle. Funding and acquisition potential are supported in a downturn, and the combination of price, quality and an attractive dividend makes it an optimal choice for investors looking for some protection.

Gilead is not just defensive, it’s a good idea in a low-return market

The classic adjustment for investors expecting a downturn or a tough market environment is to move into defensive sectors such as healthcare that are generally detached from the economic cycle. Companies such as Gilead will continue to produce revenue and cash flow through a recession as treatments like HIV medication simply can’t be discontinued to cut costs. That makes Gilead a good option for investors looking to add some defensive names to their portfolio as market risks and valuations rise to concerning levels. Defensive stock prices should hold up better in a downturn, but perhaps more importantly, investors are also less likely to sell in a panic as they see companies like Gilead continuing to produce attractive earnings rather than threatening to collapse. Investors looking for a broader solution can consider defensive sector ETFs such as the Health Care Select Sector SPDR ETF (XLV).

Market timing is tricky to impossible, but there are several reasons why investors might want to consider more defense beyond just the headline risks of Middle East tensions and the approaching US presidential election. There is no doubt that the current bull market is aging, and with the S&P 500 climbing nearly 29% last year largely due to multiple expansion and buybacks, risks are growing that stock price appreciation in the coming years will be muted. According to CNBC’s Market Strategist Survey, the S&P 500 is expected to be up a tiny 2% in 2020.

CNBC Market Strategis Survey shows low expected stock market returns for 2020.

Source: CNBC

If the probability of lower stock price appreciation is elevated, the importance of safe dividends and attractive dividend yields grows substantially. We agree with institutions such as Bank of America (NYSE:BAC) and Goldman (NYSE:GS) that moving at least partially into dividend-paying strategies makes sense to hedge against increasing risk, but importantly, also to seek out-performance as a larger portion of returns is set to come from income (such as dividends) than price movement. There are several ETF options to gain exposure to dividend-focused stocks, the largest of which are the Vanguard High Dividend Yield ETF (VYM), the SPDR S&P Dividend ETF (SDY) and the iShares Select Dividend ETF (DVY).

For many investors, defensive sector or dividend ETFs might be the best options. But others may want to seek superior returns with company-specific opportunities. We have concerns with historically defensive ETFs and strategies. Some sectors, such as consumer staples, may be defensive in nature, but their current valuations are substantially higher than historic norms which may partially corrupt their defensive effectiveness. Dividend strategies also include expensive stocks and may not have a view on dividend safety or growth. High-yielding defensive companies like Gilead with safe and growing dividends may lead to improved results, especially if valuation is attractive. In fact, Gilead’s forward dividend yield above 4% beats the yield offered by many dividend-focused ETFs.

Gilead’s valuation provides protection in today’s market

What goes up must come down. That saying is about 200 years old, but the US Federal Reserve (Fed) seems determined to prove it wrong. For defense-seeking investors still skeptical of the Fed’s ability, looking for things that have not gone up recently might be a good strategy. Of course, what we’re really getting at here is that there is protection in depressed valuations, especially when applied to high-quality companies. Stock market indices are near all-time highs on the back of valuations that might be described as inflated. Curious investors have no doubt seen several charts detailing the elevated levels of market valuation, but if we re-focus on Gilead with the graphic below, we can see just how big of a gap there is between the company’s price to earnings (P/E) ratio and that of the market.

Gilead Sciences has a cheap valuation in absolute and relative terms.

Source: Refinitiv Datastream

Gilead is trading at an eye-catching 9.3x earnings, leaving the market essentially twice as expensive. Of course, earnings per share growth for Gilead is expected to be essentially zero in the near term, meaning its earnings multiple perhaps deserves to be lower. But we can also counter that argument by reminding investors that Gilead’s return on equity and return on invested capital are far superior to the market average, closing the gap of deserved P/E ratios from our perspective. We argue that the no-growth P/E of Gilead should be closer to 12.5x, considering the company’s quality and a reasonable cost of equity. And if the company can produce any growth, the superior return on equity profile suddenly becomes much more valuable.

The point is not necessarily that we think Gilead currently offers good value, but that the market’s valuation has risen to arguably stretched levels over the last decade while Gilead’s has not. And in a downturn, the market’s earnings (and earnings growth expectations) will likely fall while Gilead’s business has a fighting chance at staying stable. In simple terms, the market has farther to fall than Gilead.

Remaining on the valuation topic, there has been substantial attention paid to the decade-long out-performance of growth stocks versus value stocks. One side effect has been record valuation dispersion between expensive stocks and cheap stocks.

The valuation gaps between growth and value and expensive and cheap stocks are at extreme levels.

Source: Ken French Data Library, Bernstein analysis, CNBC

Growth once again beat value in 2019. The prudent investor may very well want to increase value’s share in portfolios in expectation of the valuation gap beginning to close. Gilead’s single-digit P/E and strong value creation put it firmly in the value camp.

Don’t forget Gilead’s strong balance sheet and stable (or growing) revenue

We can’t talk about defense without mentioning the balance sheet. A critical attribute to defensive investments is that they stay out of financial trouble in a tough market environment. Optimally, companies can easily self-fund the business through recessions without drastic cuts to investment. With elevated current debt levels, there are a number of companies set to struggle if the financing tap is turned off or if interest rates rise. Gilead has well over $20 billion in cash and has close to zero net debt. Annual free cash flow is near $7 billion derived from a defensive business, more than securing Gilead’s financial needs even in the event of a deep recession. The company’s balance sheet will keep it out of trouble, but also keep investors from panic-selling and corrupting returns in a tough market.

Gilead’s ample cash flow also creates option value. Investors often discuss potential acquisitions to boost growth and diversify revenue streams. If there really is a downturn, it will be much easier for Gilead to find attractively priced targets to effectively turn cash into new growth drivers.

This article is not focused on specific growth drivers as there are plenty of articles detailing different growth scenarios, but it is important to note that Gilead’s revenue will likely be stable or better, supporting the defensive nature of the company. The company’s HIV business represents over 70% of revenue and is growing double-digits. There is also clear growth potential from China, Yescarta and CAR-T, Filgotinib and acquisitions. Ultimately, the valuation of the company is more than supported by just the HIV business, leaving potential growth from other areas as essentially a free option. But rather than pushing the growth argument, this article mainly proposes that Gilead offers attractive defensive attributes for most portfolios even if growth is close to zero.

Conclusion: It’s time to protect portfolios with Gilead

US stock markets are near record highs and record valuations. Expected market returns for 2020 are minuscule, increasing the importance of dividends for superior performance. It may very well be time to shift portfolios in a defensive direction, but there are few easy opportunities to do so. Most defensive sectors do not trade at bargain prices while few quality companies offer much margin of safety in today’s markets.

A rare exception is Gilead Sciences. Gilead’s business is not linked to the economic cycle and the company offers reliable value creation at a bargain price. The attractive and safe dividend will support superior relative returns in a muted market environment while the company’s strong balance sheet offers financial protection and creates option value in the form of potential acquisitions. It’s time to play defense with Gilead.

Disclosure: I am/we are long GILD. 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.

Additional disclosure: The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed to or by the author. This article does not constitute investment advice.