Does Novartis Pass Buffett's Test?

We'd all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital, or ROIC, to help determine whether a company has an economic moat -- the ability to earn returns on its money above that money's cost.

In this series, we examine several companies in a single industry to determine their ROIC. Let's take a look at Novartis (NYSE: NVS  ) and three of its industry peers, to see how efficiently they use cash.

Of course, it's not the only metric in value investing, but ROIC may be the most important one. By determining a company's ROIC, you can see how well it's using the cash you entrust to it and whether it's actually creating value for you. Simply put, it divides a company's operating profit by how much investment it took to get that profit. The formula is:

ROIC = net operating profit after taxes / Invested capital

(Get further detail on the nuances of the formula.)

This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers, and it provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficiently the company uses capital.

Ultimately, we're looking for companies that can invest their money at rates that are higher than the cost of capital, which for most businesses is between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.

Here are the ROIC figures for Novartis and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Novartis

11%

10.7%

15.5%

13%

Merck (NYSE: MRK  )

10.1%

12.8%

6.9%

19.9%

GlaxoSmithKline (NYSE: GSK  )

17.6%

26.6%

26.4%

28.7%

Pfizer (NYSE: PFE  )

10.8%

9.4%

8.4%

15.7%

Source: S&P Capital IQ. TTM = trailing 12 months.

Of the listed companies, only GlaxoSmithKline meets our 12% threshold for attractiveness. However, its returns have declined by more than 11 percentage points from five years ago. Novartis and Pfizer both come close to meeting our 12% threshold, but they've also seen some declines in their returns from five years ago. However, all of these companies offer healthy dividends: Novartis at 3.4%, Merck at 3.6%, GlaxoSmithKline at 4.2%, and Pfizer at 3.3%.

Novartis is active in both the proprietary and the generic drug markets. This diversity offers key benefits. While proprietary drugs can help a company's profits skyrocket, they also expose businesses to rapid drops in revenue as patents expire and regulatory changes cause consumers to pursue lower-cost options. While Novartis' involvement in the generic drug market may not offer the same growth potential, it can help the company maintain more steady revenues.

The expiration of Merck's Singulair asthma drug patent leveled a hit to the company's revenues. However, it has some promising drugs in its pipeline that may be able to increase revenues in the future, including diabetes treatments Januvia and Janumet and cholesterol drug Vytorin.

Pfizer has faced patent-cliff issues of its own, as the expiration of its Lipitor patent has caused a massive drop in Lipitor's sales. The company has tried to make up for the loss in revenue by reducing staff to cut costs. Pfizer also has some new drugs that may help improve its revenues, including blood clot treatment Eliquis and rheumatoid arthritis treatment Xeljanz.

GlaxoSmithKline recently acquired lupus drug Benlysta through its purchase of Human Genome Sciences. This acquisition also gives GlaxoSmithKline access to several promising drugs that were in Human Genome Sciences' pipeline. The company is also working with a company in India to create a single vaccine that guards against polio, hepatitis B, and whooping cough as part of a larger strategy to expand into emerging markets.

Businesses with consistently high ROIC show that they're efficiently using capital. They also have the ability to treat shareholders well, because they can then use their extra cash to pay out dividends to us, buy back shares, or further invest in their franchise. And healthy and growing dividends are something that Warren Buffett has long loved.


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