By the time you have made your way to my site, you have already read Benjamin Graham’s The Intelligent Investor. You’ve gone through Warren Buffett’s annual letters to shareholders of Berkshire Hathaway. And you’ve read Philip Fisher’s Common Stocks and Uncommon Profits.
Once you figure out the general rules that you are going to use to guide your investment decisions, the next step is the application. How do you connect the timeless philosophical principles that lead to long-term superior investment performance to actual circumstances in real life?
Philip Fisher wrote in his book that: “The wise investor can profit if he can think independently of the crowd and reach the right answer when the majority of financial opinion is leaning the other way. Usually, there is a need for patience of big profits are to be made from an investment.”
There are a lot of ways to apply this sentiment, but my favorite is looking for non-cyclicals that are growing profits at a solid rate but not quite a rate that the professional investor class was looking for.
I like it because less dexterity and guesswork about the future when you already are evaluating a business with existing profits. In 2008 and 2009, when the profits at Citigroup, Lehman Brothers, Wachovia, and Bank of America disappeared, it took an incredibly specialized skill set to figure out which of those banks would return to profitability and recover versus those that would go bankrupt. It would be a lot easier to turn your gaze of financial sector investing to a company like Aflac, which was trading at 6x profits that refused to deteriorate during the financial crisis and collecting all these stable insurance premiums in Japan where it conducts 80% of its business. Once you identify a business like Aflac, you don’t have to figure out the future of Citigroup, Lehman, Wachovia, and Bank of America. You can put it in your too hard pile and move on.
But if you are going to liberally define your too hard pile, you better pipe up when opportunities crop up that fall square in the middle of one’s circle of competence.
An example I saw today was the fall in CVS Caremark (CVS), which fell from $83 to $69 today on the news of intense Walgreens competition that threatens CVS’ Maintenance Choice program which fills 90-day prescriptions through the mail or at CVS locations to connect pharmacies with customers and the drug insurance companies.
In particular, Walgreens lobbyists have been far more effective than those at CVS, and Walgreens is starting to take away some government business that used to belong to CVS. The Department of Defense’s TRICARE program now conducts business exclusively through Walgreens and excludes CVS. With Prime Therapeutics’ Medicare Part D plan, CVS has been designated to a non-preferred partner.
Does this information impair CVS’ intrinsic value? Of course it does.
The question, though, is how much? For how long? And has there been an overreaction?
I wrote last week that the valuation, mixed with future growth expectations, worked so heavily in CVS’ favor that it would be an excellent investment in the low $80s. Here at $70, the terms of the deal are that much better, and the prospective shareholders get that much of a better deal.
When you look at the number expectations for 2016, CVS management has barely budged. It looks like earnings are only going to come down about $0.08. But if you look at expected 2017 net profits, there has been a heck of a revision from $6.53 to $5.90. CVS management is basically saying that CVS’ short-term earnings power has been comprised by 9.6%. In light of this, today’s 10-13% fall doesn’t seem like much of an overreaction.
For me, it always comes back to valuation. If CVS earns $5.90 per share next year, it is trading at 11.8x next year’s earnings. My view is that this valuation gives you a lot of coverage to absorb additional bad news, and will enhance future returns when the next ebb and flow in the business cycle works in CVS’s favor. I mean, heck, revenues at CVS are up 15% this year and are expected to go up 5% next year even adjusting for the lost business. It is not a lamentable occasion to see superior growth turn into modest growth for brief periods here and there.
I remember last year when BHP Billiton caught my attention as it fell below $30. I started writing about it then. Subsequent to that, the dividend was cut and the stock price of the British shares (BBL) fell to the $17 range. Other than when I write articles about tobacco stocks without patronizing my audience with moralizing, it marks the most criticism I have received in running the site.
Does that kind of stuff bother me? No. It did when I first started writing finance articles at the age of 20, but I realized three things: (1) A supermajority of investors, whether they acknowledge it outwardly or not, want neat and tidy 10% returns every year and cannot stomach true volatility; (2) a stock price going down over a significant period does not end the story, as Coca-Cola shareholders that bought at the $40 IPO in 1919 and saw the price fall to $19 before going on to generate $10 million by 2015 can attest; and (3) even Jeremy Siegel received death threats for pointing out that the internet stocks of the 2000s were crazy overvalued. Too many people harbor the view that events go from happy outcome to happy outcome with no adverse circumstances in between.
In the case of BBL, the shares are now up to $31 per share. If you were able to buy at $17 in January, you made a lot of money through today. If you bought in the $20s when it caught my attention, you have still generated a short-term profit despite ongoing difficulties in the commodities sector. The emotions regarding BBL and other commodity producers in January were overly dramatic, and the consequence is a lot of wealth got forfeited by those that acted impulsively and sold BBL shares then. Likewise, a lot of wealth failed to materialize by those who ignored the opportunity when the stock was in the teens because they were affected by the short-term headline risk.
When I study CVS right now, I see the latest iteration of this perpetual in which Mr. Market acts, to paraphrase Billy Joel, as a conveyor of either sadness or euphoria.
Phil Fisher said that you should buy growth stocks when something happens to get them down. Warren Buffett characterized the 1974 market as “the opportunity to buy Phil Fisher growth stocks and Benjamin Graham growth stock prices.” That quote didn’t get included in the Fortune magazine at the time, but it a great descriptor of an ideal holding.
While I don’t think CVS has gotten cheap enough to be considered a Ben Graham price, it would be fair to say that “CVS at $70 gives you the chance to buy a Phil Fisher growth stock at a discounted market price.” That quote may not have the crisp wit of what Buffett would say, but it nevertheless signals the opportunity to make some market-beating profits at this valuation.
CVS has a long history of growing revenues at a double-digit rate, and that has translated into high earnings growth. The shareholders have encountered a bump today, but profits are expected to grow over the 2016-2017 comparison period even as CVS has a bit of a workout coming for its Maintenance Choice program.
Long histories of double digit revenue growth and a valuation in the 11-12x earnings range for a non-cyclical corporation is an entry point you can be confident of. CVS at $70 would be a fair investment even if there was no growth. Here, you actually get mid single digit growth during turmoil and a realistic possibility of double-digit earnings growth over the next five years.
Time and time again, people fail to apply the value investing principle of purchasing shares when the stock becomes unfashionable and the valuation is cheap. When sets CVS apart from many of the other stocks I cover is that it is much growthier. When I write about BP or IBM, the money you are making is mostly through dividends and valuation shifts. CVS is a special case because the future wealth coming will be the result of valuation changes as well as earnings growth. Buying CVS at $70, grabbing a stock certificate, sticking it into a safe deposit box, and letting it be for fifteen years will get you superior results to the BP’s and IBM’s of the investment world because you are getting P/E expansion mixed with high earnings growth–a fantastic combination for excellent total returns.
The greatest advantage that you have over professional investors is that you have an unlimited time horizon. The investment world is filled with people who get fired if they underperform the S&P 500 for one, two, or three years. They have to ask themselves the questions: What will go up in six to twenty-four months? That is a tough way to make a living because you not only have to figure out what will happen, but when it will happen, and the timeliness and degree to which other investors will appraise the what and when.
If you initiate a long-term position in CVS, you get to focus on the what. The thesis can simply be: CVS will be earning profits that are a lot higher than they are now five to ten years from now, and the P/E ratio will be higher than 12. I can’t tell you whether it will be 2017, 2018, or 2020 when earnings hit a double-digit range. I can’t tell you when the investor community will push the stock price up to 17x earnings. But if you are patient, it is not necessary to make that determination. You can buy the stock around $70, and sit back and know that a lot of money will be made when the sentiment regarding CVS changes, and there is a strong enough infrastructure in place to have a high level of confidence that it will. More than anything else, the current pessimism regarding CVS leads me to conclude that it is the best way to approximate Phil Fisher style investing in real time.