LONDON -- Successful investors use a disciplined approach to picking stocks, and checklists can be a great way to make sure you've covered all the bases.
In this series I'm subjecting companies to scrutiny under five headings: prospects, performance, management, safety and valuation. How does GlaxoSmithKline (GSK -0.83%) (GSK -0.83%) measure up?
1. Prospects
The pharmaceutical industry is riding a demographic wave of aging populations in developed countries and increasing wealth in developing ones. However, many companies are suffering competition from generic manufacturers as patents expire.
GSK is one of the world's biggest drug makers, giving it the firepower to spend heavily on R&D, and it has a promising pipeline. Vaccines and consumer health care products (30% of sales) provide stability and the latter helps GSK's big push into emerging markets.
2. Performance
Turnover has been gently declining in recent years, but this trend is expected to reverse as new drugs come on stream from the end of this year. Operating profit has been variable, but GSK earns gross margins above 20%.
2.5 billion pounds per year has been stripped out of costs in recent restructurings, and the company expects to strip another 1 billion pounds by 2016.
3. Management
Sir Andrew Witty started with the firm as a graduate trainee and has been CEO since 2008. He has steered the strategy of diversification, penetration of emerging markets, and cost-cutting. He also dealt effectively and decisively with past regulatory abuses in the U.S.
The chairman is City grandee Sir Christopher Gent, who took Vodafone from a start-up to FTSE 100 membership. Together with a former Goldman Sachs M&A banker as finance director, the board is a formidable deal-making machine, but perhaps not excessively risk-averse.
Directors have substantial shareholdings.
4. Safety
GSK's balance sheet is its Achilles' heel. Net gearing is 240%. However, the debt is mostly long term, with about half having a maturity over five years. Reassuringly, interest cover is a healthy nine times.
15 billion pounds of GSK's 6.7 billion pound equity is represented by intangibles, so tangible net assets are negative. But nearly 10 billion pounds of the intangibles is patents and brands, which have real monetary value.
Cash conversion is good, with 90% of GSK's profit before tax flowing through as cash. Fixed costs of interest, dividends, capex and R&D still leave surplus for share buybacks.
5. Valuation
A historic price-to-earnings ratio of 16.8 looks expensive, but it drops to 13.2 on a prospective basis. The stock is yielding 4.8%, rising to 5.1% next year, and the fat yield in a defensive sector is the reason many investors hold the stock.
GSK has a superlative track record of rising dividends over 20 years, though sometimes that's meant dividend cover has dropped to 1.25 times.
Conclusion
Despite its over-geared balance sheet and the industry's patent cliff, GSK is a relatively safe play with a juicy yield to reward investors, and promising prospects.
One of GSK's biggest shareholders is Invesco Perpetual's star fund manager Neil Woodford. Nearly a quarter of his 22 billion pound funds are invested in just three companies in the pharmaceutical sector, including GSK.
Woodford has an unrivaled record for stock-picking. His high income fund is "the best performing of any fund investing in the UK since it launched," according to Hargreaves Lansdown. It has grown at 12.6% a year since 1988.
You can learn more about how Woodford selects stocks, and the identity of his other pharmaceutical investments, in a new report from The Motley Fool: "Eight Shares Held By Britain's Super-Investor." You can download it by clicking here -- it's free.
