What Makes a Stock "Cheap"?

If you're looking to stuff your portfolio with a few little cheap stocks this season, make sure you know how to choose between undervalued steals and junk about to crash and leave you with nothing.

On this episode of Healthcare Industry Focus, Kristine Harjes and Todd Campbell give some background context investors should know about the sector, how to look at under-$5 stocks, which areas in the industry can be expected to expand and which will probably shrink, and a few picks for stocks that are just undervalued and some that probably won't see a recovery any time soon.

A full transcript follows the video.

This podcast was recorded on Dec. 21, 2015 for release on Dec. 23, 2015.

Kristine Harjes: Who's ready for stocking stuffers? This is Industry Focus. Hi, everyone, I'm Kristine Harjes, your host of Industry Focus, healthcare edition. It's Dec. 23, and I'm joined on Skype by Motley Fool contributor Todd Campbell. Todd, it's a pleasure, as always, to have you on the show. Thanks for being here.

Todd Campbell: Glad to be here, especially talking about stuffing of stocks. I'm doing my last-minute shopping right after we finish recording.

Harjes: So, this is quite timely. So, in light of the holiday season and also just because here at The Motley Fool, we love a good pun, today's theme, if you picked up on it, is STOCKing stuffers. So, stocking stuffers are generally more inexpensive little gifts that you put in the stockings. They're supposed to be pretty cheap. 

So, Todd and I decided on this theme, and we were like, "Okay, what sort of companies should we consider here?" So I did a poll on Capital IQ, trying to find companies with a share price of less than $5. And I came up with this list, I refined it a little bit because I didn't want any of these tiny little market cap stocks. So, I did $250,000 or above in market cap. And we're looking at this list, and we're like, "This is kind of all coal." Did anything stand out to you, Todd, in that list of the worst of the worst, in that list of priced-under-$5-stocks?

Campbell: Yeah, you and I were both looking at it thinking, "Yeah, I think I would rather get coal than any of these in my stocking."

Harjes: At least coal's not going to go down in value. Hopefully.

Campbell: Right, I can always burn it if I need to.

Harjes: And put some light back in your life after all the losses on the rest of these stocks.

Campbell: Right. I think this is something that's really important to hammer home. We've talked about it before in the show. Usually, stocks get down, in a price basis, to these quote-unquote "cheap" levels, and people think they're cheap. They're really not. Oftentimes, stocks have low stock prices for a reason. Without a doubt, when we were looking through this list, we'd see names like MannKind (MNKD 0.24%). These are troubled companies that I don't think I'd recommend anyone wrapping and sticking under the tree or in the stocking this year.

Harjes: Yeah, MannKind is trading at about $1.50 a share right now. This is a company that we've covered before. They only continue to have more and more problems. The backstory on them is that they developed an inhalable insulin called Afrezza, which sounded really promising and ended up not being too promising due to a number of different problems, and the story only gets worse from there.

Campbell: Yeah. The drug had a circuitous path toward the FDA, finally received approval last year, went on the market in February, there's a licensing deal with Sanofi and Sanofi is the one who's out there repping it. A lot of people had high hopes for that deal, because Sanofi also markets the top-selling diabetes drug Lantus. So far, though, it just hasn't happened. $5.5 million in sales through 2.5 quarters.

Harjes: And this is a drug that was supposed to be a blockbuster, meaning, a billion dollars.

Campbell: Yeah. The concept was pretty darn good -- allow people to no longer have to rely on injecting themselves, which is something that obviously makes some people wince, and instead deliver the insulin via an inhaler that works a lot like an asthma inhaler.

There were some advantages that Afrezza has, including a fast onset of action. But, when push came to shove, doctors so far have found it too onerous to try and convince insurers to pay for it and be able to adhere to some of the things on the label, such as the regular lung function tasks. It's a sad situation, because it's one of those things where the drug looked really good, but it shows you that you can have a really interesting drug, but it doesn't necessarily mean that there's a market for it.

I think, in this case, they spent tons of money in bringing this to the market, and now trying to get it in front of people, and that cash is starting to run out. And you just have to wonder how long this company's going to remain around in its current form.

Harjes: Yeah. The CEO recently departed, Sanofi has the option of backing out, and they very well might do that pretty soon.

Campbell: MannKind owes Sanofi a lot of money. MannKind is supposed to be eating up some portion of the losses, and MannKind doesn't have the money to pay Sanofi for those losses, so they've basically just been banking them, and it's basically like a loan that they're supposed to be paying interest on.

At some point, the company may look at it and say, "Either we're going to collect, and MannKind goes solvent, and we're going to take all their assets that they pledged as collateral; or, we're just going to wash our hands of the whole thing and walk away." So, yeah, that's a "coal" stock for 2016, not one that I would want to get underneath the tree.

Harjes: I agree. Another one that I think we'd both consider coal would be PDL BioPharma (PDLI), which, right now, is trading for $3.83 a share. So, again, you say, "Oh my gosh, that looks cheap." What stands out about them is that they pay a 16.5% dividend yield, which is the highest in healthcare, and really just an insane number. So, at first glance, you might see that and say, "Wow, this is a hidden gem right here."

Campbell: Back in the late '90s and early '00s, when I was really involved in the sell side and doing some other things, I remember PDL was the thing, because they had this fantastic technology, monoclonal antibody patents that were going to revolutionize how we treat various conditions. That indeed has happened. The problem is, patents only last a certain amount of time.

And PDL, basically, what they did is the licensed these patents out to people like Roche. Roche made billions off of this, paid a royalty back to PDLI, however, now, those patents have expired, and they're just rolling through whatever is left in inventory. That means the revenue that has been coming in from these royalty streams is going to start drying up. I think investors have to recognize that when you see a stock trading at $3 or $4 that has a high dividend yield, there's probably a good likelihood that that dividend yield is not sustainable.

Harjes: So, what looks like it might be cheap clearly is not actually a good deal. And that's really the heart of it -- when you're looking for a bargain stock, you don't want to just look at just share price. It's like, if you're looking to stuff your kids' stockings, and you go to the dollar store and buy a bunch of stuff for $1 that's really worth well under that.

The flip side of that, an actual good bargain, like Black Friday sales or something where you pay $500 for a TV that's $2000. That's not going to fit in a stocking, but still. Two very different types of cheap that we're talking about here. So, Todd, what makes something a good bargain, if it's not just low share price?

Campbell: People have to look at it -- I love how you just summed that up, by the way. That's fantastic. It's like a Black Friday sale, where you just bought something at 25% of the price. You're getting a great deal on it, it's a fantastic way of looking at it. And I think people need to approach the stock market the same way. If a stock gets down to $5, there's probably a reason that other people don't want to own it. What you need to look at is, "What is the company's current product demand? Are they raking in sales? Are their sales growing? What's their profitability? Is it growing? Are their earnings growing?"

And then, you have to say, "What do I think the future looks like for this company? Will demand continue?" So, you're considering a few different things. When you start looking at cheap that way, you start saying, "Okay, what can I buy as far as companies out there that are growing and doing well, and not have to pay a lot of money on in terms of price-to-earnings ratio, how much the share is divided by earnings-per-share that's expected, forward earnings." When you start looking at it that way, you find plenty of bargains that you can throw in the stockings.

Harjes: Yeah, this forward P/E metric is a really handy way of saying, "Oh, wow, this stock is a bargain." Of course, there's more to it. You want to really dive in and do your research. Seems a good time to throw it out there that, as always, people on the program may have interests in the stocks they talk about, Motley Fool may have formal recommendations for or against them, so do the research, don't buy or sell based just on what you hear today. And, in doing that research, definitely check out the forward P/E ratio.

So, in this episode, we're looking at 2016 earnings, and the multiple that a couple of stocks are trading at for 2016 expectations. One that stood out to us, and this is no surprise, we talk about this company all the time, Gilead Sciences (GILD -2.51%) trading at 8.66 times its 2016 earnings expectations. That's pretty cheap. But why? Why is that number so low?

Campbell: This is a stock that you could argue is mispriced because people have continually bet against it for the last year by thinking that competitors would come out and launch drugs that will challenge its leadership in the hepatitis C indication, and that that money would therefore disappear from Gilead's revenue and profit stream, head to these other competitors.

That has not happened. Viekira Pak was a drug that was approved by AbbVie that launched in January. Sure, it's going to do a couple billion in sales, but last quarter alone, Gilead Sciences' two hepatitis C drugs were on pace to deliver more than ... I think the annualized rate, almost $20 billion annualized, exiting Q3. 

So, yes, there's competition, and we have to be aware of that competition, and there's some new competition coming. Merck & Co. has PDUFA date coming up, an FDA decision date coming up early next year. But few companies have been able to do a better job at insulating their market share against competition than Gilead.

They've done it for years in HIV, they're already starting to demonstrate that they had similar success here and hepatitis C, you've got a cheap company on forward price to earnings because people don't think they can continue to deliver the revenue and earnings that they have been. And I think that might be creating an undervaluation that investors can take advantage of.

Harjes: Yeah, I think as soon as Gilead can finally prove that they can overcome these competitive threats, which they have already shown time and time again that they can. But there remains this doubt in the market. So, as soon as people start to have faith in Gilead, which I certainly think is coming down the pike, that's when you should see, hopefully, the stock appreciate and become a great buy if you get it now.

Campbell: You look at it and say, "What's a fair price for this? Is it less than 9 times forward earnings? Or maybe it's 12? Or 15?" So then, if you take that $11, say, in 2016, and you put a multiple on it of 12, you can get a pretty good idea how much upside opportunity there could be for this company. And that's just if they can hold on to the market share that they have now. It doesn't have anything to do with their other efforts to try and expand into other indications.

Harjes: Yeah, this is a company with a very deep pipeline. Moving on to another stock that we thought sounded pretty promising and kind of cheap, is Pfizer (PFE -3.18%).

Campbell: Pfizer is a favorite company for investors to have disliked since 2012, because they had lost patent protection on their $13 billion megablockbuster Lipitor, a cholesterol-busting drug. And obviously, if you lose patent protection on a drug that's generating that much of your revenue, that's going to be pretty hard to replace. You fast forward, though, a few years, and it could be that the quarter is going to turn for this company. And if it does, then paying less than 14 times forward earnings to buy this stock may make a lot of sense.

Harjes: Yeah, this to me remains a long-term investing story. Everything we recommend on the show is a long-term situation. You should buy and hold for at least five-plus years. But for me, especially Pfizer -- this is not a company that is going to see a ton of growth in the next year, I would say. But it pays a really solid dividend, 3.75%, and because of that, it attracts a lot of long-term investors, which will reduce your volatility a little bit, and meanwhile, they've got a lot of irons in the fire.

They've got IBRANCE, which is their breast cancer drug, that should hit blockbuster status sometime in 2016. The recent Hospira acquisition to get into biosimilars, that should be an enormous market, and combat the threat that the company is experiencing from other competing biosimilar companies, Eliquis, the next-generation blood thinner -- there's just really a lot of things that could go well for this company, but it's going to take some time to really start to see more growth.

Campbell: This is one that maybe you sock away this Christmas and next. I think a lot of people are extrapolating the weakness they've suffered the last few years continuously out into the future. And if this company can return to mid-single-digit growth in 2016 and then build upon that as we move further into the year, and expectations for 2017 start getting priced in, I don't see a reason why you can't have the stock trade nicely higher for investors.

Harjes: We mentioned biosimilars a little bit. As a refresher, that's basically at the generic version of a biologic drug, which is what a lot of drugs that are coming off patent soon are. It's a biologic, it's a little bit more difficult to develop, so making a generic version has not been quite as easy. But, this looks like it's going to be a huge market going forward, and that's where the next stock we want to talk about comes in.

Campbell: The last stock we're going to chat about today -- maybe we'll throw another in if we have more time -- is Mylan Labs (MYL). Mylan is a really intriguing company because shares got really beat up this past year over its plans to try to buy a competitor, Perrigo. That deal has fallen through. They tried to do a hostile attempt to buy the company, they did not get the number of votes that they needed to make that happen.

So now, Mylan's board is looking at it and saying, "Okay, we need to get back to the business at hand, which is building up our market share in generic drugs." Generic drugs are more than 80% of all drugs that are prescribed now. We have a longer-living, older population, and their demand for drugs going forward is not going down. It's going up. So, by most accounts, you look at that and say, "Okay, what does that mean for demand for generic-drug makers like Mylan?" It's a tailwind, and a big one.

IMS is a healthcare research company, they track the industry. They think that spending globally on drugs could increase by 30% up to $1.4 trillion by 2020. That's an additional $350 billion or so between 2015 and 2020 that's going to be spent on drugs, and a heck of a lot of that is going to end up being spent on generics.

Harjes: Yeah. You've already seen a huge boom in generic drugs, because the mid-90s were a big time for generic small molecule drug development. So, over the last six years or so, that's really when all those patents have started to expire. 2012 was the peak of that, you saw $53 billion in branded drugs lose patent that year, it's absolutely still hitting now.

But going forward, when you turn over to the biologic drugs, it's expected that in the next five years, $100 billion in biologics revenue is going to lose patent. So, you look at what's happened already the past five to 10 years in the boom of generic drugs, and then you add into that the biosimilar market, and it looks like it could be really savvy to buy a company like Mylan.

Campbell: There are hundreds of drugs that are biologics on the market that'll lose patent protection. There are hundreds more under development now that will be coming to the market, over the course of the next decade, they will eventually lose patent protection.

These are expensive drugs, they're hard to manufacture, and most people believe that the profit margins that generic drug makers will get from selling these drugs is going to be bigger than what they've collected historically from small molecule generic medicines. So, there is an opportunity here that is pretty big, and I think if investors take any one takeaway away from the stocking-stuffer episode, it's that this could be a trend that you want to pay attention to, because it could have multidecade-long legs for the industry.

Harjes: Absolutely. Thanks so much, Todd. Hopefully Santa is out there among our listeners, so he knows exactly what we're looking for in our stockings. Happy holidays, everyone!