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Ken is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The market for prescription and over-the-counter drugs is huge and hugely profitable. With the global trend of an aging population well underway, it is nearly inevitable that demand for prescription and non-prescription drugs will rise. While much is made in the media regarding the so-called “patent cliff” faced by the large drug makers, well-placed investments now will allow investors to reap double-digit gains for years to come. Investors who are willing to buy during high uncertainty do very well when everyone wakes up later — and that is the situation with the drug industry today.
Drug companies in all shapes and sizes
Publicly-traded drug companies come in all shapes and sizes, from small biotech firms to giant international powerhouses with market capitalization in the hundreds of billions of dollars. Some have no products on the market and some have massive numbers.
Unless one is blessed with a technical understanding of the industry or medicine, evaluating this type of business is a matter of wading through oceans of numbers and finding the businesses that offer value. This can become an arduous task given the diversity of the industry and the pending expiration of large numbers of significant patents.
Among some of the well-known names such as Eli Lilly (NYSE: LLY), GlaxoSmithKline (NYSE: GSK), Pfizer (NYSE: PFE) and Abbott Laboratories (NYSE: ABT) there seems to be enough variation in the valuations to create an opportunity for investment, as indicated from the data in the table* below.
*Information shown in this table compiled from data on MSN Money
One quick way to estimate the fair value of a business is to take the sum of the projected five year earnings growth rate plus the dividend yield and compare it to the next year’s earnings estimate. Based upon that calculation, GlaxoSmithKline would be the least expensive of the group with a fair value of 11.33 times 2014 earnings versus an actual number of 12.78 for a multiple of 1.13, followed by Abbott Labs with a multiple of 1.26. The negative that stands out for GlaxoSmithKline is the high debt-to-equity ratio of 3.15. The obvious positives for Abbott Labs are the lowest payout ratio of the group and the massive cash holding and short-term investments as a percentage of total market capitalization, at approximately 25%. This positions Abbott well in regard to potential acquisitions, dividend increases and new drug development. Considering the conservative 44% payout ratio and the overall trend in the market today of returning excess cash to shareholders, it would not be surprising to see higher dividends or share repurchases from Abbott.
Good businesses, highly valued
Investing in stocks is about more than just finding good businesses–that is only half of the equation. The price at which we buy an investment is instrumental in determining our ultimate profit.
Lilly and Pfizer are excellent examples of good businesses that are well run but simply priced too high at the current time to justify investment with a realistic expectation of double digit returns over an extended period of time. Both carry high payout ratios to support the existing dividends, and the projected earnings growths rates for both could best be described as modest.
These are both large, stable businesses but investors in either should be willing to accept total returns between 5% and 8% a year over the long term. While those are not horrible numbers when compared to government bonds or interest on savings, it is not what I am willing to accept when taking on the risk of stocks.
Roll the dice on a one-trick pony
Those wishing to take on a larger risk with an inexpensive drug stock with only one product might wish to take a close look at Questcor Pharmaceuticals (NASDAQ: QCOR). It’s one product is H.P. Acthar gel. The stock was hammered last fall due to concerns surrounding insurance reimbursements for off-label uses. Those concerns now appear to have been overblown, and a more detailed discussion of the business can be found here. Questcor is scheduled to report earnings on April 30, and I expect the stock to move higher on strong results.
Final Foolish thoughts
Investors seeking relative safety and out-sized performance should consider investing in Abbott and GlaxoSmithKline. Those with a gambler’s soul may wish to consider a position in Questcor in front of the next earnings report.