Is Your Mutual Fund on Drugs?
If it isn't, maybe it should be.
Given the meltdown of financial stocks and the gyrations of energy and commodity-related shares, it's been easy to miss what's happening in other parts of the economy and financial markets. However, the health-care sector, which has certainly had its share of problems over the past few years, is attracting some interest from some of Morningstar analysts' favorite mutual fund managers.
Slowing growth and weak development pipelines in pharmaceuticals, ballooning cost of care outstripping insurance premium raises, product liability lawsuits, and Justice Department investigations into device firms' payments of physicians are some of the problems that have blighted the sector's landscape. In this piece, we'll review some of the problems with pharmaceuticals and managed-care providers, specifically, and discuss which intrepid fund managers--all of whom manage funds that are among our Analyst Picks--are diving into these industries with the belief that the stocks have gotten too cheap.
First, the advent of biotechnology, which uses living organisms or biological processes to make medicines, has taken some of the luster from traditional pharmaceutical companies, whose therapies are based on chemicals. Traditional "big pharma" has also suffered in recent years from a lack of blockbuster drugs such as Viagra, Lipitor, Zocor, Vioxx, and Prozac, which made Pfizer (PFE), Merck (MRK), and Eli Lilly (LLY), among others, darlings of growth investors in the late 1990s.
The numbers tell the story of big pharma's plight. For example, Pfizer's revenues surged from $13.5 billion in 1998 to $52.5 billion in 2004 (a whopping compound annual growth rate of 25%), but shrank from $52.5 billion in 2004 to $48.4 billion in 2007. Pfizer also hasn't been able to match the $14 billion of operating earnings that it generated in 2004 in the three years since. As a result of slower revenue and earnings growth, pharmaceuticals are now more likely to find themselves sitting in value indexes than growth indexes, where they once competed for prominence with technology stocks.
The stock prices of many pharmaceutical companies have accordingly deflated or stagnated over the past few years, as moderating sales and earnings growth have caused investors to lower their expectations. Pfizer's price/earnings ratio was generally more than 30 (often substantially so) from 1998 through 2001, while it's currently around 15. Pfizer also traded at more than 10 times sales in 1998, while it now trades at a little less than 3 times sales. Clearly, the market has taken note of slowing growth.
Add to this situation fears of a nationalized health-care policy that might impose price controls on drug companies and shrink profits, and you have an industry, whose growth has already slowed, beset by political uncertainty regarding its future. If there's one thing that the market can't abide and penalizes in spades, it's uncertainty, and the recent prices of pharmaceutical stocks are no exception.
Managed Care's Margin Compression
Uncertainty regarding national health-care policy has also pounded the managed-care companies recently. Moreover, on the heels of an options-backdating scandal that hurt UnitedHealth Group (UNH) in 2006, the industry's biggest players haven't raised insurance premiums commensurately with the ballooning cost of care, which has served to crimp their profit margins in 2008. For example, according to Morningstar equity analyst Matthew Coffina, UnitedHealth's "medical cost ratio" (medical costs as a percentage of premium revenue) deteriorated to 83.2% in the second quarter of 2008 from 80.3% from the corresponding quarter of 2007. Also, WellPoint's (WLP) medical cost ratio for the second quarter of 2008 was 83.3% compared with 81.8% for the same quarter of 2007.
As in the case of the pharmaceuticals, the market has duly noted the managed-care firms' difficulties. UnitedHealth trades at its lowest price/earnings and price/book ratios in a decade, while WellPoint, which trades at around 10 times earnings, had typically traded between 14 times and 20 times earnings since it had become a public company in 2001.
So, have the prices of drug and managed-care stocks dropped commensurately with the respective decline in growth and margin compression? Or have the prices fallen below the intrinsic value of these businesses because of the market's natural tendency to overreact combined with the political uncertainty? Simply speaking, are the stocks in these industries too cheap? Some of our favorite fund managers seem to think so.
First, Fairholme Fund (FAIRX) lead manager Bruce Berkowitz has trimmed his fund's energy position and deployed the proceeds from the sale into health-care stocks. Berkowitz sold a chunk of oil and natural-gas producer Canadian Natural Resources (CNQ) in the spring of 2008, reducing its position in the portfolio from about 15% of assets to about 7%, and purchased Pfizer and WellPoint, which, together, now soak up 15% of Fairholme's assets. Additionally, Fairholme has 7% of its assets in mid-cap drug firms Forest Laboratories (FRX) and Mylan Laboratories (MYL). In his recent shareholder letter, Berkowitz cites all of the negative arguments we've discussed, including slower growth, pipeline concerns, rising costs, and political fears, but contends that these stocks have underlying businesses providing essential products and services and generating large free cash flows relative to Fairholme's purchase price. Basically, fear has made these stocks too cheap, and Berkowitz, following Warren Buffett's dictum, notes that he likes to be greedy when others are fearful.
In addition to the Fairholme team, the managers at Dodge and Cox have their recently re-opened flagship fund, Dodge & Cox Stock (DODGX), chock-full of pharmaceuticals such as Sanofi-Aventis (SNY), Novartis (NVS), GlaxoSmithKline (GSK), and Pfizer along with biotech Amgen (AMGN), insurer WellPoint, and drug-and-supplies distributor Cardinal Health (CAH). In fact, around 22% of Dodge & Cox Stock's portfolio (nearly twice the weighting of the S&P 500 Index) is in health-care stocks. Filings show that many of these stocks have been in the fund for years, though the team appears to have bought Novartis with a vengeance over the past 18 months or so. Management notes in its recent shareholder report that it has increased the percentage of pharmaceuticals alone in the portfolio from 2% to 14% over the past eight years as prices have declined. Furthermore, Dodge & Cox estimates that the six pharmaceutical giants that it owns spend about $30 billion per year collectively on research and development, which, though having yielded disappointing results recently, should eventually lead to promising new drugs. Finally, pharmaceuticals have opportunities for margin improvement with cost-cutting and for revenue growth in emerging markets. In general, Dodge & Cox thinks current prices of the stocks reflect very low expectations for future growth.
Our third group of managers loading up on health care is the team that runs the Primecap funds, including Vanguard Primecap Core (VPCCX). Recent data show that the fund has 24% of its assets in health-care stocks, including four of its top-five holdings, Eli Lilly, Novartis, Medtronic (MDT), and Amgen. Roche, Glaxo, and Boston Scientific (BSX) are the other top-25 health-care holdings. The Primecap team has invested in pharmaceuticals and established biotech firms while avoiding the managed-care companies. In their recent shareholder report, the managers remark that "the advances in the treatment of certain diseases such as Alzheimer's, diabetes, and cancer will create significant opportunities for pharmaceutical and biological health care companies in the future." The Primecap managers also discussed their health-care holdings with Morningstar mutual fund analyst David Kathman recently, and they remarked that Eli Lilly's drug for preventing blood clots in patients with artery stents, although still in trials, has the potential to become a blockbuster. Generally, the team thinks other investors are too pessimistic about the possibility of future profitable drugs.
It so happens that Morningstar's own equity analysis mostly corroborates the opinions of these managers. There are currently 59 health-care stocks trading in 4- or 5-star territory, according to Morningstar's analysis. Pharmaceuticals in 5-star territory include Merck, Mylan, Novartis, Pfizer, Sanofi, and Schering-Plough (SGP). Additionally, UnitedHealth and WellPoint are still deep in 5-star territory (well below Morningstar's fair value estimates and Consider Buying prices) despite recent runs.
The best managers tend to gravitate to areas of the market that are unloved, and that seems to be the case with their moves into health care. That doesn't mean that the bold bets of these three management teams will pay off immediately. Of course, they also could be simply wrong; perhaps the market is correct in its pessimistic assessment of these firms' future growth. Even in this unfortunate scenario, however, the downside protection at current prices seems to be significant, especially for the pharmaceutical companies, with their strong free cash-flow generation and rock-solid balance sheets.
John Coumarianos has a position in the following securities mentioned above: NVS. Find out about Morningstar’s editorial policies.