Yes, this article you are about to read is a first-world problem. Throughout this past year, I have made no secret of the fact that Visa and Gilead Sciences are two of my favorite companies if you are looking to buy-and-hold blue chip stocks with well above-average growth rates. Over the past five years, Visa has grown profits at 22.5% annually. Gilead, meanwhile, has grown profits at 15.5% annually for the past five years. Even if the growth at both companies comes down a bit, it still figures to be above the 10% annual range throughout the rest of the decade.
That’s what prompted me to write highly praiseworthy articles of both companies over at Seeking Alpha earlier this year, such as “Visa’s Fall To $200 Is Classic Short-Term Thinking” and “Gilead Sciences Has A Realistic Path To $100.” Visa is now at $248. Gilead is now at $102. The price change in both these stocks has been quite significant. Visa has gone up 24% (plus dividends) since I wrote that article in April. Gilead Sciences has gone up 14% since I first wrote about it in July.
Now, the predicament is this: Both of these companies are still on pace for double-digit earnings per share growth. It is unlikely that you could build a portfolio consisting of many blue-chip stocks with faster growth rates than these two. But…the margin of safety principle concerning these two companies has changed by a meaningful amount of the course of this year.
Visa made $9.07 for its 2014 business year. At $248 per share, we are talking a valuation of 27x earnings. Put another way, your situation is this: you get a 0.77% dividend yield, 3.65% starting earnings yield, +the future growth rate of the firm. My concern is that a chunk of the company’s future earnings growth has already been priced into the stock. I have the company penciled in to make $15 per share in 2019. My estimate of fair value would be a valuation in the 20-25x earnings range. That would imply a 2019 stock price between $300 and $375.
My concern with adding Visa now is that there is no margin of safety in the event that the company’s growth fails to meet expectations. What if Visa only grows at 7%, and trades at 21x earnings five years from now? That’s certainly within the realm of possibilities. In that case, Visa would be making $12.86 per share in 2019, and at a 20x earnings valuation, would trade at $257 per share, just a little bit above where we are now. That’s something you need to keep in mind—what if growth is slower than you expect, and because the growth slows down, the P/E ratio comes down with it as future expectations simultaneously diminish? It would be a double whammy—lower reported profits, plus a lower multiple applied to those profits occurring at the same time. I find that bothersome: If Visa grows at 7% annually from here, you could surrender all of those gains due to P/E compression occurring at the same time. The company would be growing moderately, but your reported returns would be negligible in such a scenario.
In the case of Gilead, my concern is this: Everything is going right with the company right now. Sovaldi, the wildly successfully and wildly expensive Hepatitis C drug, has taken flight. Gilead’s profits per share have increased from $1.64 in 2012 to $1.81 in 2013 to $7.80 in 2014. The company is flush with cash, sitting on $8.7 billion. There are about 200 million HCV patients in the entire world, and it’s expected that Gilead will be providing pills to half of them.
My concerns about Sovaldi are two-fold. I think it is possible that some analysts are over-estimating the profits that this drug will be able to generate for shareholders. When Sovaldi was first marketed in the United States, the price came out to $1,000 per pill. Don’t drop that down the drain. Because of its high price, Gilead has angered many governments and patients who accurately claim that people are dying because they cannot afford to pay for Sovaldi pills. In order to avoid patent invalidation in second-world countries like India, Gilead has agreed to only charge Indians $10 per pill. I suspect this will catch on elsewhere, as well as lower prices of the $1,000 pill in the United States at some point in the next two or three years.
And secondly, pharmaceutical earnings don’t go straight up—they are like oil in that there is an element of cyclicality to the business (even though handsome profits are still made at the bottom of the business cycle). Look at GlaxoSmithKline’s profits going from $3.38 in 2009 to $0.99 in 2010. Look at Eli Lilly’s profits going from $4.15 last year to $2.75-$2.85 this year. No pharma company is immune from the effects of an ebbing and flowing pipeline, and my concern with Gilead is that the company moves from strength to strength due to the surging success of one primary drug.
It makes me wonder whether we are seeing Pfizer with Lipitor all over again. Pfizer has never come close to hitting its high of $2.20 per share in profits that it realized in 2007 because the recession hit and then Lipitor went generic in 2011, and here in 2014, Pfizer is making $1.70 per share in profits (still below its 2007 highs). With Gilead, it is now generating $24 billion in annual revenue. Over $10 billion of that is from Sovaldi alone. And Sovaldi is expected to take up a higher share of Gilead’s profits in the coming years—the stock should be renamed “Sovaldi” to give a more accurate presentation of what the company is.
I would not want to bet against either Visa or Glead. If you own either, be happy that they are in your portfolio because it is likely they will deliver double-digit growth well into the future. But if you’ve yet to buy any shares, I would be patient. Right now, each of these companies are doing everything right. Their business performances and trajectories couldn’t look rosier, and that is priced into the stock of both companies. If the rosy projections come to fruition, you will do well. But the current share price does not allow for satisfactory returns in the event that future growth comes in a bit less than expected. You could have a situation where 7-8% growth of the businesses translates into no gains for you due to P/E compression. Waiting for a better entry point seems the wisest course of action—heck, it was this very year you could buy Visa at 21.5x profits. I’d imagine you’d get your price sometime in the next few years if you’re patient—good things come to those who wait and all that.
Originally posted 2014-11-15 14:28:19.