Old-School Blue-Chip Value Investing

The reason why I prefer the type of investing that is conventionally called “growth at a reasonable price” investing is because the ride is enjoyable and time is your friend. If you own a huge block of Nike stock, it doesn’t really matter that the stock has fallen from the $65+ range to the low $50+ range over the past eighteen months because the earnings keep growing at a 12-16% annual rate so it is a near inevitability that the price of the stock will be much higher five, ten, and fifteen years from now.

The favorable advantages of doing absolutely nothing but sitting back and letting the things you own compound were expressed by Warren Buffett in the 2010 letter to shareholders of Berkshire Hathaway:

“Other companies we hold are likely to increase their dividends as well. Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.”

Even with no reinvestment, Berkshire shareholders have been able to see the passive income generated from their Coca-Cola investment increase four-fold, while receiving billions of dollars in capital gains and making new investments that those Coca-Cola dividends were used to fund each year. Long-term investments in firms like Pepsi, Johnson & Johnson, Brown Forman, Colgate-Palmolive, or Coca-Cola have a salutary lifestyle effect because the additional cash they distribute to shareholders each year permits you to go on the offensive and make new investments.

Once the stock has compounded for 10+ years, you will find yourself in the position of eagerly awaiting the next twelve months because it means that more cash will be coming your way to fund new investments. It lets you arrange your affairs in such a way that the do-nothing, default option is additional enrichment as the executives at those firms are doing all the work to grow sales and increase profits that will be shared with you. A good rule of thumb is to place 50% to 75% of your overall stock-market assets into these types of firms.

But what about the rest? That’s where old-fashioned value investing comes in–the search for things that are trading at a discount and will give strong future returns as the valuation shifts from x to 1.5x concurrently with some earnings growth to give you market-beating returns over a three to five year time horizon.

One such candidate for consideration is Bristol Myers Squibb (BMY), the $88 billion health-care giant that has seen its stock price fall from $76 in July to its year low of $53 as it has shed almost 30% of its market value over the past two months.

The impetus for the decline in Bristol Myers Squibb’s stock price is that its once-promising lung cancer drug, Opdivo, did not perform well in clinical trials. It was supposed to be the next big breakthrough in the fight against carcinoma, but it didn’t even prove as effective as chemotherapy solutions that are currently available. Investors thought that Opdivo would be a $10 billion drug within ten years, and had to simultaneously digest news that Opdivo’s future is greatly diminished while seeing Merck report that its own version of the drug called Keytruda did succeed in its clinial trial to slow the spread of carcinoma.

The reason why I don’t share the “stay impulse” towards Bristol Myers Squibb stock that other investors are currently exhibiting is because the company is not facing a patent cliff that will sap earnings power in the near future. If you have evaluated a company like Eli Lilly or Pfizer over the past few years, or have analyzed Gilead Sciences’ prospects over the next few years, you have had to base your valuation off of something other than typical P/E analysis because the “E” has been an unstable figure to calculate since the earnings have fallen or will fall in response to patent expirations.

But an analysis of Bristol Myers Squibb stock leads you to a different place. The earnings stream is quite diversified, and earnings are currently understated because it earns so much money abroad in developing countries that have exhibited a weakening currency translation against the U.S. dollar since 2014. And most importantly, the Opdivo disappointment doesn’t mean that earnings are going to collapse, but rather, that the hopes for five year earnings growth in the 12-15% annual range fueled by Opdivo’s premised introduction to the marketplace is now off the table.

When I look at Bristol Myers Squibb, I see a company that is earning about $3.10 per share on a constant currency basis ($2.70 per share on a reported basis), growing core earnings at 3-5% annually, sporting a solid balance sheet position with only $6 billion in debt against $4.5 billion in cash, and offering the possibility of high single digit earnings growth if just one of its current stable of promising drugs meets expectations (here, I am talking about the potential prostate cancer vaccine Prostvac, the potential hepatitis treatment Daclatasvir, and the potential myeloma treatment Empliciti.)

In other words, with no particularly strong news to the upside, Bristol Myers Squibb ought to grow earnings to the $3.75 range over the next five years. If any of these drugs pay off, we could be revising that upward to the $4.50 range.

When you look forward to the 2021 range, this company ought to have the earnings support to trade in the $85 to $110 range. That is five year capital appreciation of 60% to 100%, and plus, you get an initial 2.8% dividend yield that ought to grow at a low single rate along the way. It is on the short list of companies that has a realistic possibility of doubling your money within 4-5 years.

That is why traditional value investing has some role in your strategy, as Bristol Myers Squibb’s stock appreciation from the $53 range to the $80+ range along with the dividends received will likely offer better three to five year returns than many of the set-it-and-forget-it investment opportunities that I discuss. And plus, the risk-adjusted aspect of the returns is also impressive, considering that we are talking a diversified stream of $5 billion that is growing at a soft rate. You get a lot of the upside that value investing seeks to capture without taking on commensurate risk of permanent capital impairment.

It continues to interest me how much people overreact to bad news in the marketplace. There are a lot of times when bad news only affects intrinsic value 5-10%, and yet the stock shoots down 15-20%. In the field of large-cap investing, a lot of investment returns could be significantly improved if the response to bad news that led to a steep price decline was: “I’m going to sit on it for three years and then reassess.” The list of billion-dollar firms that recover from adverse events is far longer than the ones that continue their journey towards value destruction because large-cap businesses have the institutional resources to mitigate damages and fund new opportunities. Bristol Myers Squibb is one such casualty that offers current investors the opportunity to beat the S&P 500 between now and the 2018-2021 range.