Baxter International Splits Off Baxalta

If you know almost nothing about investing and are looking to get started with individual stocks, large healthcare stocks are fertile soil to begin your buy-and-hold research. During 1902 through 2012, only the tobacco sector outperformed the healthcare sector in America. Tobacco stocks returned 17% annually, and healthcare stocks returned 13% annually.

The reason why I encourage starting with healthcare rather than tobacco is that: (1) units of tobacco sales decline by 3.5% annually in the United States, forcing the tobacco giants to increase per share growth through stock buybacks, price hikes, and diversification into things like e-vapor cigarettes, and (2) the healthcare industry is growing at 4% annually and may even grow faster than that rate as America ages.

There are only two customary ways that you can run into trouble with a healthcare investment: (1) you can overpay, which is a risk that applies to every possible investment, and (2) you can experience some revenue loss from drugs going off patent or products getting eclipsed when a competitor releases a technologically superior version of what you sell.

The benefit of dealing with a company that only offers these risks is that the risk of permanent capital impairment is small and time tends to work things out. Imagine buying Pfizer in July 1998. The company owned, and still does own, a wide range of intellectual property that gives Pfizer ownership over 1,000 different drugs.

Yet, 1998 would have been a poor year to invest: The stock was trading at an 80% premium compared to its usual valuation, and even then, investors should have insisted upon a discount from the usual valuation range because Lipitor would be going off patent eventually. Lipitor was created in 1996 and owned by Warner-Lambert (which eventually became a part of Pfizer) and would go on to make $125 billion in profits over its 15 years of patent protection under Pfizer’s ownership. The loss of Lipitor’s patent exclusivity reduced Pfizer’s profits by 48%. Combined with overvaluation, this was a nasty cocktail for shareholders.

And yet, look at the repair that takes place over the long haul: If you purchased Pfizer stock in the summer of 1998, you would have had a negative four percent compounding rate through 2008. Your $10,000 investment would have become $6,211. You waited ten years, and lost almost half of your money. Now look at what happens when you stretch out the evaluation period to measure the summer of 1998 through the summer of 2015. That $10,000 investment in 1998 grew to $16,000 by the summer of 2015.

Yes, that is only a 3% compounding rate of 17 years. No one desires that kind of outcome at the time they make an investment. But I subscribe to the school of thought that it is just as important–maybe more so–to avoid disaster as it is to find lucrative opportunities. It goes back to that Charlie Munger life advice that the key to success is to avoid “cocaine, racing trains, and AIDS situations.” The idea is that minimizing risks can be its own form of success.

I want avoid situations where the primary risk of an investment is a 100% capital loss. Those are the bad case scenarios I want to avoid. With healthcare stocks, you can sidestep this risk. An inopportune buy order doesn’t wipe out; it just delays the beneficial effects of compounding as the problems due to valuation or patent cliffs work themselves out.

That brings us to Baxter International: It’s a company that most people on the street have never heard of, but is a $20 billion powerhouse with a 3% dividend yield. Over the past thirty years (January 1985-January 2015), Baxter International delivered total returns of 12% annually. Even though that has beaten the S&P 500 returns over that period of 9.5% annualized, it’s actually slightly unperformed the returns of the pharmaceutical industry in general during the bulk of the 20th century.

There are four immediate primary metrics that I like about the company: (1) it has a low dividend payout ratio of 41%, compared to the average of 58% in the pharmaceutical industry; (2) the retained earnings post-dividend payout compound at 16.5%; (3) revenues have grown at 7% over the past 10 years; and (4) earnings per share have grown at 10.5% over the past ten years.

The price of the stock is down since the spinoff of the bioscience division, Baxalta, about a month ago. Usually, a company spins off a separate company because it is junk or is growing at a much faster rate. Baxalta isn’t all that distinguishable from Baxter itself–namely, Baxalta has grown revenues at 8% annually over the past ten years while Baxter has grown revenues at 7% annually.

With the spinoff complete, Baxter is now trading at a valuation of 18x profits. That is a company that normally trades around 19-22x earnings. That is attractive because those profits are not adjusted for the negative currency translation. Baxter only generates 42% of its profits in the United States. It sells products that help people cope with hemophilia, kidney disease, and immune disorders in over 100 countries.

The 21% appreciation of the U.S. dollar against other foreign currencies in general throughout the past two years has created an interesting opportunity to be exploited: people that take the time to study the figures that go into the “number” that eventually gets reported as earnings per share can create a tremendous advantage for themselves and their family by recognizing the sets of circumstances that can cause the number to be understated.

On a currency-neutral basis, Baxter has actually grown sales by 3.5% after accounting for the Baxalta spinoff. Yet, someone checking a financial portal will see 10% sales declines because of the strong effect of currency translations for this company. By my estimation, the overall earnings are understated by 8.5% due to currency adjustments that have no bearing on the long-term fundamentals of the company.

I would imagine someone buying Baxter International would beat the S&P 500 over the long run from this point. The dividend is higher than the S&P 500, the revenue and earnings per share growth is better than the typical S&P 500 stock, and the stock is just a little bit undervalued (which, in this market, is about the best you can ask for outside the oil sector.) Those three elements seem likely to combine with each other for market-beating returns. Yes, Baxalta will probably outperform Baxter from here on out. But I don’t think this is going to be like the Phillips 66 spinoff from Conoco in which the baby company left the parent in the dust. Baxter International should hold its own, even if the Baxalta results ultimately prove more enriching.