What causes some investors to fear volatility? I suspect it is that any share price decline signifies a disruption in their expectations. If you work hard and have $10,000 left over from your labor, and choose to buy an ownership stake in a business that has a track record of growing, you expect to not only see that $10,000 be maintained but grow as well. If your investment falls in value to $6,000, the evaporated $4,000 feels as though you had nothing to show for your labor. Even in instances where that investment may first rise to $16,000 but then fall down to $12,000, it still feels like a loss because we are pretty darn good at treating increases in the value of investments as though it is some permanent marker of wealth that has been rebased upward.
You may also wonder: If it is so darn unpleasant to see the value of an investment, which initially constituted the surplus value of your labor, fall in value, why put up with the volatility in the first place?
The answer to that question is one of the most important in justifying stock market investing: If you do nothing, or limit yourself to only guaranteed payments such as that of an interest-bearing checking or money market, you have placed a low ceiling on the growth capacity of your surplus labor–choosing the certainty of 1-4% annual returns over the no-guarantees-at-all approach that comes with business ownership but also opens the door to the possibility of double-digit annual returns on investment.
I open with this broad-level discourse to make a point: Volatility is the necessary condition for outsized investment performance. If you want 10% returns, you must accept it head on.
I remember writing about how attractive BHP Billiton was amidst its dividend cut during the oil price declines in 2014 and 2015. Now, the dividend has recovered and the price of the stock is over $40. Cycles are inherent.
A similar thought entered my mind in response to Gilead Sciences (GILD) stock price decline from over $80 back in January to the $65 range today. The P/E ratio is 10, and the $2.28 annual dividend gives prospective investors a 3.5% starting dividend yield at this current price point.
The basis for the price decline is just as rational as seeing the price of BHP Billiton fall when the price of oil collapsed–Gilead’s blockbuster Hepatitis C drugs have seen 75% declines in sales in response to Abbvie’s launch of a competitor drug Mavyret that has stolen market share and crippled Gilead’s Harvoni due to its much lower treatment price.
What I find compelling is that Gilead is doing what most pharmaceutical companies ought to do–diversify. It spent $12 billion acquiring Kite, which has a portfolio of CAR-T therapies that are aimed at killing cancer cells. This should add about 25% to Gilead’s top-line revenue base, though the specific figures are unprojected at this time (perhaps Gilead is learning from Harvoni that pigs get fat and hogs get slaughtered, and will price its CAR-T therapies at a lower price that doesn’t invite its competitors to become market entrants themselves due to the high profit margins available).
Aside from this, Gilead has $25 billion in cash currently on hand that it can use to make other acquisitions to augment earnings. Keep this in mind: Even with Harvoni falling off a cliff, Gilead is still a company making $8 billion in profits. Even if its Hep C portfolio were to be completely annihilated, it would still only trade at 23x earnings while bringing in $4 billion in profits.
An investor’s edge, in an overvalued market, involves paying attention to the potential power of a cash hoard to raise the overall earnings base. Just as it was inevitable that Gilead would be something like Kite, it is also inevitable that it will continue to deploy its $25 billion cash hoard to make other similarly-sized acquisitions that serve as the post-Hep C frontier.
The solace is that you get a 3.5% dividend yield which only constitutes a third of the company’s overall profits at a P/E ratio of 10.
The market is directionally correct in recognizing the decline in Gilead’s Hep C portfolio. But the magnitude has been overstated. There are certain companies–like BP, BHP Billiton, GlaxoSmithKline, and Gilead Sciences–that the investor community sometimes writes about as though they don’t generate billions of dollars per year each in cold-hard profit.
I feel bad for people who are partially informed and look at the numbers, see that a particular drug is down 75%, and choose to sell low. Look at the price history for any pharma stock–they all have multi-year stretches where they resemble a Six Flags rollercoaster. The few that don’t share this characteristics, including Johnson & Johnson, discovered the “secret sauce” of buying consumer healthcare divisions to provide a stabilized profit base when compared against the rises and falls of particular drugs.
For Gilead, the certainty that the future will be better than today is a combination of the very low valuation, the $8 billion in annual profits (including a $4 billion base excluding Hep C drugs), the accumulation of dividend payments from a now decent 3.5% yield, the acquisition of Kite, and the $25 billion that will be deployed to make acquisitions that will also supplement the earnings base. The people who buy good assets and do not micro-analyze the real but solvable issues of the day will be rewarded.