Five years ago, Boeing and Lockheed Martin stock got unusually cheap in response to a threat of sequester in which many market participants interpreted congressional posturing about reducing the budget deficit into deep cuts for the defense industry. This threat of regulation sent Boeing stock down from the $80s to the $50s and also sent Lockheed Martin down from the $80s to the $60s.
At the time, the P/E valuation for both stocks travelled to well below historical twenty-year averages. Boeing was trading at $56 while earning $4.82 per share in profits for a P/E ratio of 11.61. The threat of budget cuts never materialized, and Boeing went on to deliver 11-12% annual earnings growth through 2015 as estimated earnings grew to $8.30. The stock now trades at $117, for a P/E ratio of 14.
One of the most frustrating oft-repeated statements I encounter on message boards come from investors who say, “I don’t know how this is going to play out. Let’s take a wait and see approach as to whether the risk materializes.” The problem with this approach is that the perceived uncertainty corresponds to a cheap valuation. In these types of situations, the risk of buying into the certainty is that the perceived harm (in this case, harsh regulations that diminish earnings) will be much worse than what you expect.
But this may be a remote possibility, and the valuation of 11.6x earnings can position you to do well if subsequent earnings perform at the low end of expectations, and you are simultaneously setting yourself up to do quite well if you buy the stock and the fear appears overblown. If you bought Boeing stock during the fear of the sequester, the returns have been 15.6% annualized. If you bought Lockheed Martin at the same time, the results would be 28% annualized because the P/E ratio grew from 10x earnings to 19x earnings. Even though Lockheed Martin has greatly outperformed, I would argue that selecting either stock back in 2011 was equally intelligent because it was not foreseeable that Lockheed stock would balloon to 19x earnings five years later while Boeing’s valuation only improved to 14x earnings.
In a sentence, my argument would be this: Highly profitable, entrenched large-caps that experience a valuation drop in response to some perceived operational difficulty can often provide fertile ground for potential investment because (1) the fallen valuation is set up to “absorb” this, and/or (2) the fear never materializes into earnings harm of the magnitude anticipated at the time the news story breaks.
This is what happened to Boeing and Lockheed Martin back in 2011, and the latest iteration of this phenomenon seems to be occurring with Gilead Sciences at $82 per share. The earnings per share from the Sovaldi-reliant drug portfolio continue to climb ever higher, as Gilead reported 16.4% revenue growth and annual profits that now stand at $12.61 per share. That is a P/E ratio of only 6.5x earnings.
The reason why the price of the stock is being discounted so severely for a company that has given shareholders 36.5% annual earnings growth for the past ten years is because investors are looking ahead to Sovaldi after it loses patent exclusivity and also bracing for adverse results from the Senate investigation committee being led by Chuck Grassley of Iowa and Ron Wyden of Oregon. The Senate Committee is examining whether Gilead engaged in any illegal pricing practices and whether regulations are necessary for a drug that costs $84,000 (Sovaldi) or $94,500 (Harvoni) for a twelve-week regimen.
I do not anticipate that this Senate investigation will lead to any material harm for the Gilead Sciences business model. While the price of the Hep C treatment is enjoyable for those that need it, Gilead seems to have a strong defense–it spent $11 billion acquiring PharmAsset to gets its hands on the ownership rights to the intellectual property of Sovaldi, and the drug is notable because it provides a cure in 92% of the treatment cases. It doesn’t just keep an illness at bay; it actually provides a cure.
Usually, pricing issues in the drug industry relate to fraud or some type of deceptive marketing technique. That’s what the regulations focus on. Gilead Sciences isn’t susceptible to much of the current regulatory scheme because it is upfront about the extensive costs–it is well-known that Sovaldi has developed a reputation as the $1,000 pill. The concern surrounding Gilead is more about the mismatch between society’s sensibilities and the actual high price of Sovaldi and Harvoni rather than any allegations of misconduct that Gilead Sciences has been breaking laws associated with the development and sale of these drugs.
Gilead is wise to use extensive amounts of cash thrown off to retire stock–today, Gilead announced it is repurchasing $15 billion in stock after the previous $12 billion buyback program ends. As of this afternoon, the dividend has been hiked 10%. The amount of cash on the balance sheet is now over $26 billion, compared to $22 billion in debt (most of this is long-term debt, as Gilead only has $300 million in debt obligations maturing before December 2020).
Gilead was trading at over $100 per share at the start of the year, and the price of the stock has fallen almost 20% down to $82. Gilead was probably trading at the low end of fair value before the big January decline, and the sharp haircut in response to a senate inquiry has sent Gilead stock firmly into undervalued territory.
This is what makes markets fun–the constant overreaction to short-term news is one of the greatest ways to find a nice company at a discount. When people hear bad news about the stock they own, it is easy to overestimate the amount of hypothetical harm because of basic loss aversion evolutionary theory where people tend to assume that the future will be worse than it actually will be. Graham was on to something when he classified Mr. Market as a manic depressive that switches between depression and exuberance.
Gilead at $82 per share seems like an item of high interest, as the firm is still delivering double-digit growth and is now aggressively moving into Japan. It is now repurchasing substantial blocks of stock at 6.5x earnings, which should augment a fine core business that is growing at double-digits in its own right. Gilead was a good deal at $100, and now offers a margin of safety at $80. Earnings growth and dividends combined with P/E expansion is now in the mix for the future returns of Gilead shareholders. It’s the latest incarnation of what we saw with Lockheed and Boeing five years ago.