Part of our remit at ATPBio is to uncover value within the healthcare sector. More usually, this is in the form of working with clients to assist with strategy, asset work-up, due diligence and identifying key value drivers. Though, as we approach the festive season and thoughts turn
to the holidays, I've been looking through the US public markets to see if there are any interesting value plays we can share more broadly with all our readers.
When looking at stocks, key attributes we look for include companies with both value and growth characteristics; a stock which is undervalued AND has out-sized upside potential, along with a good dose of Benjamin Graham's "margin of safety". Value traits are defined by various ratios, principally low price-earnings (PE ratio), along with low price-book (PB), low price-cash flow (PCF) and high dividend yield (DY). These contribute to a contrarian approach – looking for stocks when they have fallen out of favour with the market (and expertly described by David Dreman in his book: "Contrarian Investment Strategies: The Next Generation"). The growth element is included by considering stocks which also have a high return on equity (ROE). While this is primarily a metric to measure management effectiveness, it is often a feature of companies that are growing earnings at a healthy rate (since they are able to re-invest profits to contribute to greater future earnings growth). By combining the two, and using well-validated data sources and stock screens (we use ValueLine), one can establish a ranking of all qualifying stocks for closer inspection. A version of this approach is simply yet expertly described by Joel Greenblatt in his book: "The Little Book that Beats the Market".
Once we've derived a ranking of stocks, we then manually check through each one, looking at additional factors including manageable debt levels for safety, and appreciation potential. By maintaining fairly strict criteria, this leads to typically finding 8-12 attractive and qualifying stock picks, out of an initial screen result of up to 100 stocks. And interestingly, since the ValueLine stock service used limits the overall universe to around 1700 of the larger US stocks, generally, the picks coming out are well-capitalised, liquid, and have a reasonable trading history of several years or more.
The key to the whole approach is to let the market tell you what is undervalued and has out-sized upside potential, rather than trying to figure it out by intense and purely fundamental stock specific analysis, and then make predicitons based on that. Although good in theory, the challenge with such pure fundamental analyses is that there are always known unknowns, and worse still unknown unknowns lurking around the corner that can scupper the best laid analysis. Or, in the words of John Maynard Keynes: "It is better to be roughly right than precisely wrong".
By adopting a contrarian approach, the bad news is already priced in and further bad news has a smaller effect, while surprising good news (not as uncommon as one might expect) can have a positively strong effect on price. Similarly, for stocks that are priced for perfection, further good news is already expected so has less effect, while unexpected bad news relating to the stock can have a disproportionately negative effect on the price. And complimenting this with ROE focuses the search on those companies that have better skilled management making more efficient use of capital. We then overlay this with some sound risk management principles (e.g. a modest diversification with around a 10 stock portfolio, and judicious use of stop-losses).
This also means since we are looking for value and growth features, we perform sector agnostic or generalist screens; deep knowledge of fundamentals does not guarantee any better performance with this approach, and no one sector has any monopoly on the best opportunities. Though, as and when we do come unearth interesting healthcare stocks, readers of this blog may find them of interest.
One such stock that came out of our recent analysis was Eli Lilly & Co. (NYSE: LLY). This may not appear at first glance to be an obvious choice – large pharma, worries over long-term patent expiries, and bedding down a reasonable sized acquisition (ImClone) – and all reasons why it may have fallen somewhat out of favour. However, when one looks at the key criteria described above, it offers good value (PE = 8x, PCF = 7x, DY = 6.1%), and has effective use of capital (ROE = 49% for 2009). And even with the almost flat-line picture on earnings, if it reverts to a sector average PE rating around 14x, this along with the healthy dividend would lead to a very respectable return over 3 years: potentially a very nice stocking filler. Such turnarounds can sometimes occur surprisingly quickly when they do take shape (e.g. see: Kinetic Concepts revisited: value or growth? – up around 40% since our June blog article).
(Tickers of other interesting healthcare stocks that were highlighted in the screen, but excluded on further analysis of the criteria included FRX, CBST, ENDP and AMGN).
Why write about all this in a life sciences blog? Well, the screens and analyses I perform usually highlight a few interesting opportunities within the healthcare listed companies space. Every investor and every manager should be aware that as well as looking for the next new big thing, and starting and building new companies, they also have a responsibility to ensure that assets (including cash) are being put to the best possible use. By thinking about opportunities in the public markets, it forces us to confront the opportunity cost that any other rational investor will always consider. It also gives us, the "little guy", the opportunity to participate in some great companies and healthcare opportunities without necessarily being an institutional investor. So, in short, while looking for diamonds in the rough, don't forget about the elephants on the plains.
(NB. Do your own research and nothing in this blog is an investment recommendation.)
This article was written by Raman Minhas. He is CEO of ATPBio, a consultancy firm providing strategic insight and transaction support to the life sciences industry. For transparency, the author does own stock in LLY.