Situation: Biotechnology companies are the high-risk sector of the US stock market. We have not previously discussed companies in this sector, aside from pointing out that Amgen (AMGN) and Biogen Idec (BIIB) had a Durable Competitive Advantage in 2012 (see Week 59). Why? Because our blog is about buy-and-hold stocks that can be expected to pay growing dividends in retirement, which is so attractive to those living on a fixed income. Biotechnology companies, on the other hand, rarely pay dividends because they make products that come off patent ~17 years after FDA approval. That means research and development of the next winning product will consume most of their profits. We’re talking about a growth industry where new technologies rapidly eclipse old technologies, and stability is a mirage.
For investors who like to gamble in the stock market, the biotech sector provides the stocks they’re likely to pick. And they’ll have many to choose from. For instance, the main exchange-traded fund (ETF) for biotech stocks is the SPDR S&P Biotech ETF (XBI at Line 11 in the Table). It tracks the S&P Biotechnology Select Industry Index, which includes 87 companies. The NASDAQ Biotechnology Index (^NBI at Line 14 in the Table) has 151 companies. The Barron’s 500 List of the largest companies by revenue on the New York and Toronto stock exchanges only has the 4 biggest names, plus AbbVie (ABBV) at Line 10 which is a recent spin-off from Abbott Laboratories (ABT) at Line 9. We’ve included ABT as a “big pharma” reference point.
Close examination of the Table, shows that Gilead Sciences (GILD) is the only one of the 4 long-established biotech stocks that is not overpriced by our main criterion, i.e., it has an EV/EBITDA (Enterprise Value divided by Earnings Before Interest Taxes Depreciation and Amortization) less than 14. On the negative side, GILD has a 5-yr Beta of 1.11 and an S&P stock rating of B/M, both of which signify earnings uncertainty. Only Amgen (AMGN) pays a dividend, has a low 5-yr Beta, and carries the minimum S&P stock rating (B+/M) suitable for buy-and-hold investors. You can take a look at the drugs currently being marketed by these 5 companies by consulting the APPENDIX at the end of this blog.
There is an issue with overpricing in the biotechnology industry, with respect to both product and stock prices. Some pharmacy benefits managers (PBMs), e.g. Express Scripts Holding Company (ESRX), will not sell the high-priced GILD drugs for treating Hepatitis C Virus (genotype 1). Instead, ESRX has entered an agreement with ABBV to sell its lower-priced Viekera Pak.
Stock prices for the industry also appear high. Amgen (AMGN) and the NASDAQ Biotechnology Index (^NBI) are more than two Standard Deviations above their 16-yr log-linear trendlines, and have been labeled “potentially overpriced” at the BMW Method website. Experienced investors will look at price/sales (P/S) when such concerns arise. P/S is ~1.8 for the S&P 500 Index. However, the healthcare industry is the most “overbought” of the 10 S&P industries. So, P/S for a typical "big pharma" company like ABT is 3.4, and the 4 biotech firms at the top of our Table have an average P/S of 8.8. It looks like biotech stocks are in a “bubble.”
Bottom Line: If you’re over 50, it is time to focus on retirement savings. You should have at least 4 times your gross annual income in that account by now. None of the 4 biotechnology stocks in our Table with 20 yrs of price data fit the requirements for inclusion in a retirement portfolio. These are high-risk, high-reward stocks. That said, they represent a more prudent bet than competing high-risk assets like gold, international stocks, and high-yield bonds. Those don’t carry anything like the reward potential of biotechnology stocks, given the tens of millions of people per year who move up from poverty to enter the “middle class” in emerging economies like China, India, Brazil, Turkey and South Africa.
Risk Rating: 8
Full Disclosure: I own shares of ABBV.
NOTE: metrics that underperform VBINX have red highlights in the Table; metrics are current as of the Sunday of publication.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
APPENDIX for Week 194
Gilead Sciences (GILD) has $7.7B in cash holdings for future acquisitions, and specializes in anti-viral drugs. Its current products include 1) Truvada is a combination of two other of the company’s drugs, Viread and Emtriva. 2) Complera is a combination of Truvada and Tibotec’s Edurant. 3) Atripla is a combination of Truvada and Bristol-Myers-Squibb’s Sustiva. 4) Stribild is so far approved for use only in the European Union (EU) and is a combination of Viread, Emtriva, elvitegravir, and cobicisat). 5) Ambisome B is marketed for life-threatening fungal infections that often complicate the treatment of AIDS. 6) Viread and 7) Hepsera are used to treat chronic hepatitis B. 8) Tamiflu is used to treat influenza A and B but is marketed by Roche (which pays royalties to Gilead Sciences until the drug comes off patent in 2016). 9) Letairis is used to treat pulmonary arterial hypertension; Gilead Sciences had to acquire Myogen to obtain its patent for Letairis. 10) Ranexa is used to treat chronic angina pectoris; Gilead Sciences acquired CV Therapeutics to obtain its patent for Ranexa. 11) Cayston is used to treat cystic fibrosis that has become complicated by infection with Pseudomonas aeruginosa. 12) Sovaldi (sofosbuvir) is used to treat Hepatitis C; Gilead Sciences acquired Pharmasett for its patent to use Sovaldi against certain genotypes of Hepatitis C in combination with the established drug treatments (interferon and ribavirin), or with ribavirin alone when patients cannot tolerate interferon. 13) Harvoni, a tablet that is taken once a day for treatment of Hepatitis C genotype 1 and is used without interferon or ribavirin. This breakthrough drug has achieved ~95% cure rates in Phase III studies.
Biogen Idec (BIIB) has $3.2B in cash equivalents for future acquisitions and is focused on producing drugs and monoclonal antibodies for cancer and autoimmune diseases. Current products include 1) Avonex (beta interferon) is the company’s core franchise, used to treat relapsing multiple sclerosis since FDA approval in 1996. The current version comes off patent in 2026. 2) Rituxan, a monoclonal antibody against CD-20 protein positive B-cells, is an FDA-approved treatment for non-Hodgkin lymphomas and rheumatoid arthritis. It is marketed by Roche via Genentech (Biogen Idec receives royalties). 3) Tysabri (developed with Elan) is FDA-approved for the treatment of relapsing multiple sclerosis. It is under limited distribution because of producing progressive multifocal leukoencephalopathy in patients carrying antibodies to the Jakob-Creutzfeld virus and/or those receiving treatment for more than two years. An assay is now available to detect the JC virus before starting Tysabri. 4) Tecfidera, an orally-dosed drug used to reduce relapses of multiple sclerosis, received FDA approval two years ago. 5) Plegridy, a long-acting version of Avonex, emerged from Phase III studies over two years ago and received FDA approval in August of 2014. 6) Ampyra, a drug produced by Acorda Therapeutics, is used to improve walking in multiple sclerosis patients. Biogen Idec obtained the license to sell the drug outside the U.S. in 2009; conditional EU approval was granted in 2011.
Amgen (AMGN) has built up $28B in cash holdings. Current products include 1) Epogen is a genetically-engineered human erythropoietin used to stimulate red blood cell production in anemia caused by chronic renal failure. 2) Aranesp is a recombinant protein that stimulates red blood cell production, and is approved for use in treating chemotherapy-induced anemia as well as chronic renal failure. 3) Neupogen stimulates neutrophil (white blood cell) production in cancer patients undergoing chemotherapy. 4) Neulesta, another stimulant for neutrophil production. 5) Enbrel is a drug for treating rheumatoid arthritis, psoriatic arthritis, and chronic plaque psoriasis that Amgen obtained when it acquired Immunex in 2002. Enbrel has been issued a new patent that extends to 2028. 6) Sensipar, sold on license from NPS Pharmaceuticals, is used to treat hyperparathyroidism secondary to end-stage kidney disease. 7) Vectibix is used to treat advanced colorectal cancer. 8) Nplate is used to treat ITP (immune thrombocytopenic purpura). 9) Prolia (denosumab) is used to treat bone loss due to hormone ablation, postmenopausal osteoporosis, or metastatic prostate cancer.
Celgene (CELG) has $6.9B in cash holdings and specializes in using its proprietary small molecule technology to develop drugs that modulate the immune response or inhibit cytokine production--mainly to treat multiple myeloma. Current products include 1) Thalomid (thalidomide) inhibits blood vessel growth and is used to treat leprosy-related illnesses and multiple myeloma. 2) Revlimib, the successor to Thalomid, is used to treat myelodysplastic syndrome and relapsed or refractory multiple myeloma. 3) Pomalyst was approved for use in refractory multiple myeloma in 2013, and is in Phase III studies for potential use in myelofibrosis. 4) Otezla was approved for treatment of psoriatic arthritis in 2014, and is in Phase III studies for potential use in ankylosing spondylitis as well as being up for FDA approval to treat psoriasis. 5) Abraxane (via acquisition of Abraxis BioScience in 2010) is approved for use in metastatic breast cancer, non-small cell lung cancer and pancreatic cancer. 6) Istodax (via acquisition of Gloucester Pharmaceuticals in 2010) is used to treat T-cell lymphoma. 7) Otezla (apremilast) is used for treatment of psoriatic arthritis.
AbbVie (ABBV) has $10B in cash and investments but also carries long-term debt of $14B.
Current products include 1) Humira, the injectable tumor necrosis factor (TNF) blocker that is the leading treatment for rheumatoid arthritis worldwide. It is also approved for use in juvenile idiopathic arthritis, psoriasis, ankylosing spondylitis, ulcerative colitis, Crohn’s disease, and spondyloarthritis. Its US patent expires in less than two years; competing drugs include Remicade and Simponi (both marketed by Johnson & Johnson) as well as Enbrel (marketed by Pfizer). 2) Tricor and Trilipix, for use in treating high cholesterol or high triglycerides, went off patent in 2012. 3) Niaspan, an extended-release niacin supplement. 4) Synthroid, a long-standing staple for treating hypothyroidism. 5) AndroGel (testosterone replacement therapy). 6) Lupron, for prostate cancer. 7) Synagis, for treating respiratory syncytial syndrome, is only marketed outside the US. 8) Kaletra and Norvir, for treating HIV.
Sunday, March 22
Sunday, March 15
Week 193 - Barron’s 500 Companies with 25 years of Below-Market Variance in Stock Price Appreciation
Situation: Now that US stock and bond markets appear to be fully valued, it is time to pause and reflect. The metric we refer to as Finance Value is derived by subtracting risk from reward. But what is reward and what is risk? Reward is stock-price appreciation (plus appreciation due to reinvested dividend payments) over the long term. Let’s call it the 25 yr period that for most people is the most active time of saving for retirement. Risk can be summed up by a term from statistics: variance.
As defined at the Investopedia website, variance is “a measurement of the spread between numbers in a data set. The variance measures how far each number in the set is from the mean. Variance is calculated by taking the differences between each number in the set and the mean, squaring the differences (to make them positive), and dividing the sum of the squares by the number of values in the set . . . Since variance measures the variability (volatility) from an average or mean, and volatility is a measure of risk, the variance statistic can help determine the risk an investor might take on when purchasing a specific security.” What does this mean in practical terms? Variance tells us how closely a company skirts the edge of oblivion (bankruptcy). The quickest way to track variance is to always check out the S&P credit report.
The S&P 500 Index has 4-5 times the level of variance that is found in an investment grade bond index. If stocks represent more than 25% of your retirement savings, you'll feel pain from a stock market crash. (Stocks can go down a lot just when you need the money.) The solution is to overweight bonds in your portfolio, or buy shares of a mutual fund that will do that for you (e.g. VWINX at Line 20 in the Table). However, few people who haven’t been to business school can embrace that idea of overweighting bonds. Why? Because it is much more entertaining to own stocks, and the incentives are greater. Those incentives include 1) greater returns over the very long term; 2) greater transparency of valuation metrics; 3) a narrower spread between bid and ask prices; 4) dividend payments that track earnings vs. interest payments that are fixed; 5) earnings growth that usually stays ahead of inflation, whereas, bonds lose value with inflation. Bondholders, however, benefit from two distinct advantages: 1) the return of principal upon maturity of the bond, whereas, stocks merely provide a return on principal; 2) in the event of bankruptcy, bondholders get money from the sale of assets but stockholders get nothing.
We'll look at several measures of risk over a 25-yr time period, to see if we can come up with a few stocks in the Barron’s 500 List that are less risky than the S&P 500 Index by every one of those measures.
We’ll start with the “BMW Method” to examine variance in CAGR (compound average growth rate) for stock prices over the past 25 yrs. This analysis will tell us the rate of price appreciation arrived at from the “least squares” calculation defined above for daily prices over 25 yrs. Applying the "least squares" test creates a trendline for the logarithm of daily prices. The BMW Method data set has 25-yr log-linear plots for the stocks of 560 companies, revised forward at the first of each month. At the BMW website, you’ll find that each regression line (of price over time) has two parallel lines above it and two parallel lines below it. Those represent one or two Standard Deviations (1SD or 2SD) from the rate of price appreciation. For example, the S&P 500 Index (^GSPC) has a 25-yr price appreciation of 6.4%/yr and the -1SD CAGR is 20% less (5.2%/yr).
In the Table, we list the 25-year rate of price appreciation in Column Q and the Standard Deviation (plus or minus 1SD or 2SD) in Column R. Most stocks, and the S&P 500 Index, are currently “on trend.” We’ve excluded companies whose current stock prices are 1SD or 2SD off trend, since that represents the volatility we’re trying to avoid. We’ve also excluded stocks that have a 5-yr Beta greater than the 5-yr Beta for the hedged S&P 500 Index (VBINX at Line 22 in the Table), as well as stocks with a 25-yr growth rate that has greater variance than the S&P 500 Index. Stocks that haven’t exceeded their best price in last bull market, which ended in October of 2007, are also excluded. In addition to these variance criteria, we’ve excluded companies that lost more than the 46.5% that the lowest-cost S&P 500 Index fund (VFINX at Line 24 in the Table) lost during the 18-month Lehman Panic. And, we’ve excluded companies with S&P bond ratings below BBB+ and/or S&P stock ratings below B+/M.
Only 15 companies remain (Table). Its not surprising that 11 of those are Dividend Aristocrats, i.e., companies that have been growing their dividends annually for at least 25 years (see Column V in the Table).
Now let’s look at valuation metrics like P/E and EV/EBITDA (Columns J and K in the Table). And, we’ll add a new twist: PEGY (Column N), which is P/E divided by two metrics: estimated 5-yr rate of Growth in earnings (Column L) and dividend Yield (Column G). Recall that any P/E higher than 20 suggests that the stock is overpriced, since earnings yield then falls below 5%. Similarly, any company with an Enterprise Value that is more than 13 times higher than year-over-year operating earnings is overpriced (in our opinion). For PEGY, we think any number over 2.0 suggests that the stock is overpriced while any number under 1.2 suggests that the stock is underpriced. Taking these 3 metrics together (P/E, EV/EBITDA, and PEGY), which of the 15 stocks flunk all 3 tests? There are 4: CLX, CL, KO, HSY. The only stocks that are not overpriced by any of those 3 metrics are: McDonald’s (MCD), Microsoft (MSFT) and Comcast (CMCSA).
Bottom Line: This week we’ve tried to take the sting out of the stock market by finding stocks that have a 25-yr history of being less risky than the S&P 500 Index by every one of several volatility tests. We found 15, and 12 of those companies happen to be “defensive” stocks as defined by Standard & Poors (i.e., companies in the Consumer Staples, Healthcare, Utilities, and Communication Services industries). Then we looked at valuations, finding that 4 of the 15 are pricey by 3 metrics: P/E, EV/EBITDA, and PEGY. Those 6 are balanced by 5 stocks that aren't pricey (McDonald’s, Microsoft and Comcast).
Risk Rating: 4
Full Disclosure: I dollar-average into WMT and MSFT, and also own shares of PG, PEP, KO and MCD.
NOTE: Metrics in the Table are brought current as of the Sunday of publication; red highlights denote underperformance vs. the Vanguard Balanced Index Fund (VBINX).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
As defined at the Investopedia website, variance is “a measurement of the spread between numbers in a data set. The variance measures how far each number in the set is from the mean. Variance is calculated by taking the differences between each number in the set and the mean, squaring the differences (to make them positive), and dividing the sum of the squares by the number of values in the set . . . Since variance measures the variability (volatility) from an average or mean, and volatility is a measure of risk, the variance statistic can help determine the risk an investor might take on when purchasing a specific security.” What does this mean in practical terms? Variance tells us how closely a company skirts the edge of oblivion (bankruptcy). The quickest way to track variance is to always check out the S&P credit report.
The S&P 500 Index has 4-5 times the level of variance that is found in an investment grade bond index. If stocks represent more than 25% of your retirement savings, you'll feel pain from a stock market crash. (Stocks can go down a lot just when you need the money.) The solution is to overweight bonds in your portfolio, or buy shares of a mutual fund that will do that for you (e.g. VWINX at Line 20 in the Table). However, few people who haven’t been to business school can embrace that idea of overweighting bonds. Why? Because it is much more entertaining to own stocks, and the incentives are greater. Those incentives include 1) greater returns over the very long term; 2) greater transparency of valuation metrics; 3) a narrower spread between bid and ask prices; 4) dividend payments that track earnings vs. interest payments that are fixed; 5) earnings growth that usually stays ahead of inflation, whereas, bonds lose value with inflation. Bondholders, however, benefit from two distinct advantages: 1) the return of principal upon maturity of the bond, whereas, stocks merely provide a return on principal; 2) in the event of bankruptcy, bondholders get money from the sale of assets but stockholders get nothing.
We'll look at several measures of risk over a 25-yr time period, to see if we can come up with a few stocks in the Barron’s 500 List that are less risky than the S&P 500 Index by every one of those measures.
We’ll start with the “BMW Method” to examine variance in CAGR (compound average growth rate) for stock prices over the past 25 yrs. This analysis will tell us the rate of price appreciation arrived at from the “least squares” calculation defined above for daily prices over 25 yrs. Applying the "least squares" test creates a trendline for the logarithm of daily prices. The BMW Method data set has 25-yr log-linear plots for the stocks of 560 companies, revised forward at the first of each month. At the BMW website, you’ll find that each regression line (of price over time) has two parallel lines above it and two parallel lines below it. Those represent one or two Standard Deviations (1SD or 2SD) from the rate of price appreciation. For example, the S&P 500 Index (^GSPC) has a 25-yr price appreciation of 6.4%/yr and the -1SD CAGR is 20% less (5.2%/yr).
In the Table, we list the 25-year rate of price appreciation in Column Q and the Standard Deviation (plus or minus 1SD or 2SD) in Column R. Most stocks, and the S&P 500 Index, are currently “on trend.” We’ve excluded companies whose current stock prices are 1SD or 2SD off trend, since that represents the volatility we’re trying to avoid. We’ve also excluded stocks that have a 5-yr Beta greater than the 5-yr Beta for the hedged S&P 500 Index (VBINX at Line 22 in the Table), as well as stocks with a 25-yr growth rate that has greater variance than the S&P 500 Index. Stocks that haven’t exceeded their best price in last bull market, which ended in October of 2007, are also excluded. In addition to these variance criteria, we’ve excluded companies that lost more than the 46.5% that the lowest-cost S&P 500 Index fund (VFINX at Line 24 in the Table) lost during the 18-month Lehman Panic. And, we’ve excluded companies with S&P bond ratings below BBB+ and/or S&P stock ratings below B+/M.
Only 15 companies remain (Table). Its not surprising that 11 of those are Dividend Aristocrats, i.e., companies that have been growing their dividends annually for at least 25 years (see Column V in the Table).
Now let’s look at valuation metrics like P/E and EV/EBITDA (Columns J and K in the Table). And, we’ll add a new twist: PEGY (Column N), which is P/E divided by two metrics: estimated 5-yr rate of Growth in earnings (Column L) and dividend Yield (Column G). Recall that any P/E higher than 20 suggests that the stock is overpriced, since earnings yield then falls below 5%. Similarly, any company with an Enterprise Value that is more than 13 times higher than year-over-year operating earnings is overpriced (in our opinion). For PEGY, we think any number over 2.0 suggests that the stock is overpriced while any number under 1.2 suggests that the stock is underpriced. Taking these 3 metrics together (P/E, EV/EBITDA, and PEGY), which of the 15 stocks flunk all 3 tests? There are 4: CLX, CL, KO, HSY. The only stocks that are not overpriced by any of those 3 metrics are: McDonald’s (MCD), Microsoft (MSFT) and Comcast (CMCSA).
Bottom Line: This week we’ve tried to take the sting out of the stock market by finding stocks that have a 25-yr history of being less risky than the S&P 500 Index by every one of several volatility tests. We found 15, and 12 of those companies happen to be “defensive” stocks as defined by Standard & Poors (i.e., companies in the Consumer Staples, Healthcare, Utilities, and Communication Services industries). Then we looked at valuations, finding that 4 of the 15 are pricey by 3 metrics: P/E, EV/EBITDA, and PEGY. Those 6 are balanced by 5 stocks that aren't pricey (McDonald’s, Microsoft and Comcast).
Risk Rating: 4
Full Disclosure: I dollar-average into WMT and MSFT, and also own shares of PG, PEP, KO and MCD.
NOTE: Metrics in the Table are brought current as of the Sunday of publication; red highlights denote underperformance vs. the Vanguard Balanced Index Fund (VBINX).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
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