CVS-Caremark Not So Hard to Swallow

Someone once said that the way to be a successful investor is to sit quietly and patiently, until you see a pile of money lying in the corner and then go over and pick it up. Easy to say, but hard to do for most people.

In a previous column, I spoke about Benjamin Graham, the Columbia University professor whose most famous student was Warren Buffett. Graham is widely considered to be the "godfather" of value investing. The parable he often quoted to describe market behavior and value investing involved "Mr. Market," a whimsical character who came knocking at your door day in and day out, offering to sell shares in some company at a price that fluctuated wildly each day.

As a value investor, your job was to buy shares in this company when Mr. Market was selling them at a discount, or what Graham called "below their book value." Why would Mr. Market do that? No particular reason, really. You see, being the whimsical fellow that he is, Mr. Market is capable of doing anything, even if his actions appear irrational to you and me.

Money in the corner
Mr. Market, of course, is a metaphor for the actions of investors collectively, and we all know they do act irrationally sometimes. Smart individuals can prosper by taking advantage of the opportunity that investor irrationality presents. In effect, Ben Graham's advice is equivalent to "Go and pick up the money lying there in the corner." It's about being patient and seizing opportunity.

Without question, Warren Buffett has taken this advice to heart for most of his investing career, and now he's the second-richest man on the planet. He might have even surpassed Bill Gates to become No. 1 on the rich list if not for his recent lapses of discipline that had him chasing silver and shorting the dollar -- investment follies that Ben Graham hardly would have condoned.

To achieve the results (in rate of return) of Buffett's pre-silver days, one has to stick to value-driven basics. In addition, it wouldn't hurt if some long-term demographic and macroeconomic policy trends were powerfully floating the boats, so to speak. This brings me to retail pharmacy chains -- specifically, CVS (NYSE: CVS  ) .

An intriguing pair
Last week, emotional investors dumped CVS shares when the company announced that it will merge with Caremark. (Think of those dumped CVS shares as the pile of money left in the corner.) Why did investors sell CVS? Who knows? Perhaps they just couldn't see the logic of the combination or got spooked by the $21 billion "cost." More likely, the move was just another example of irrational behavior (a.k.a. Mr. Market).

Much of the recent analytical discussion and, indeed, criticism of this deal and the drug industry in general, focuses on pricing. While a case can be made that big pharmaceutical companies face pricing challenges ahead, particularly now that the Democrats have more power, price concerns in the retail and mail-order space miss the big picture -- Wal-Mart's $4 prescription-drug plan notwithstanding.

The big picture I'm talking about is sales, which is by far the most important long-term trend when it comes to prescription medication. While actual prices may be capped or even come under pressure, sales are on the rise and are likely to be sustained by two enormous and virtually unstoppable forces: the aging population (no one can reverse that, unfortunately) and rising government spending on prescription drugs (which is very unlikely to reverse).

In the face of these tsunami-like tendencies, investors' micro-focus on pricing seems odd to me. Why? Because business profits can be generated by a number of factors, higher prices being just one. Profits can also go up when sales increase or when costs go down, or with some combination of all three -- prices, sales, and costs. However, in today's competitive world, the most certain path to higher profits is usually by economy of scale, vast sales, and reduced cost. This is exactly the model that the CVS-Caremark merger intends to put to use. I believe it will work.

The health-care opportunity
Look at some recent history: CVS has seen its sales grow by $17 billion, or 65%, since the prescription drug bill became law at the end of 2003. Compare that with the much lower 30% sales gain that the company experienced in the previous three-year period. Furthermore, nearly half of that sales gain is occurring this year, when the full impact of federal spending on drugs is really starting to kick in. Going forward, the effect is likely to be that much more. All told, the government is expected to spend more than $1 trillion in the next 10 years. This will unquestionably mean higher sales for retail pharmacy chains and mail-order houses such as Caremark. Moreover, with their gigantic combined size, it should translate into lower costs (read: economies of scale).

Imagine for a moment that you had the foresight to buy defense stocks when Ronald Regan was elected back in 1980. Reagan ran on a platform of strong national defense, and almost from the minute he was sworn into office, defense stocks started to rise. You could have bought those stocks and never looked back ... if you were able to connect the dots.

The same is true with drugs and, in a larger sense, with health care in general. This is particularly so with the Democrats now setting the legislative agenda in Congress. In her victory speech, Hilary Clinton confidently reasserted one of the party's primary goals -- a national health-care plan. You'd better believe this will continue to include government subsidies of prescription drugs, perhaps even broadening the universe of beneficiaries beyond seniors and those on Medicare.

Perhaps you find this prospect horrifying, or perhaps you believe it's the start of socialized medicine in this country. But it would probably be better to ignore those feelings and think like an investor, because profound, policy-driven trends like these come along only once or twice in a generation. If you recognize them and climb aboard early, you can become very, very rich.

Then you won't have to worry about the cost of health care. You'll be able to afford the best.

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Fool contributor Mike Norman is an international economist and founder of theEconomic Contrarian Update. He can be seen on Fox News, where he appears as a business contributor. In addition, he hosts a radio show on the BizRadio Network. He does not own shares in any of the companies mentioned. The Motley Fool has a disclosure policy.


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