Drip Portfolio Report
Tuesday, October 7, 1997
by Randy Befumo (TMF [email protected])

ALEXANDRIA, VA (Oct. 7, 1997) -- Greetings, Drip Portfolio readers. It has been such a long time since a report of mine has graced this page I wanted to say hello and reintroduce myself. You know, Randy Befumo, co-Drip Portfolio manager? Remember me? The spunky kid who thought looking at Owens Corning would be a fun time?

Just kidding. The reality is that due to massive confusion in the readership, Jeff and I decided to shift the way we wrote the Portfolio two weeks ago. Instead of dancing back and forth in the middle of our analysis, we would go start to finish. Since Jeff was pretty far along with the healthcare overview and he won two out of three games of "Rock, Paper, Scissors," I let him go first. Now that he has taken the Drip Portfolio to the brink of a buy recommendation, I figured I would comment on this for two days and then blissfully return to the nirvana of analyzing KANSAS CITY SOUTHERN (NYSE: KSU). For those of you who have done your homework, never fear -- we will grade it on Thursday.

Over the past few weeks, Jeff has looked at four companies in the reports and two outside of them (Merck and Warner Lambert). Of the group, he is now favoring JOHNSON & JOHNSON (NYSE: JNJ), although he expresses a great passion for the business of PFIZER (NYSE: PFE). Because Jeff has narrowed it down to these two names, something that I think makes a lot of sense, rather than boring you with my impressions of companies we are not seriously considering I figured I would go straight to the heart of the matter.

The Drip Portfolio emphasizes buying a business for twenty years. However, this does not mean that you throw valuation discipline out the window. It is being disciplined about valuation that makes the difference between a market return and market outperformance. Buying an earnings growth story is not enough. The valuation of your earnings growth story has to either remain stable or expand for you to have half a chance of outperforming the market. The right company at the wrong moment, even one share at a time, can really hurt your ability to create wealth over the long term.

Right now Pfizer trades at 32.5 times the consensus earnings estimate for 1998. Twenty-eight analysts have estimates ranging from $1.90 to $2.12 EPS, a pretty tight range with both a mean and a median estimate of around $2.00 EPS. Over the past five years, earnings growth has been 15%, two percent greater than the industry's 13% growth rate. Analysts believe that the growth rate will accelerate to 18% over the next five years given Pfizer's generous pipeline of products and its continued research and development expenditures that are well above the industry average.

Pfizer's current trailing price/earnings ratio has been unfortunately increased due to this bulge in research and development spending in the past year, among other factors. Earnings growth this year versus last year will likely only be around 12.7%. Investors who buy Pfizer today buy the promise that the growth rate will accelerate. From this level, if the company's earnings growth rate does not increase to 18.0%, there is quite a bit of risk at the current price. Even giving the company a substantial premium to its growth rate for high cash flow and return on invested capital, 32.5 times fiscal 1998 is close to twice the rate of growth and 50% higher than the current P/E on the average S&P 500 company.

Even when you have a twenty-year time frame, if you initially buy a company that could quite possibly go nowhere for three to five years, it takes a long time to make up for that mistake. Time frame never excuses a lack of valuation discipline when purchasing a company, in my opinion. The valuation on Pfizer leaves investors at relative highs from a valuation standpoint. The one thing that makes me think that Pfizer might not disappoint is that in spite of the emphasis on research and development spending, the company is on track to potentially surpass its stock repurchases in 1994. In the first two quarters of 1997, the company has already surpassed the buybacks of 1995 and 1996 combined. In the first quarter alone, the company repurchased more stock than in all of 1995 and 1996.

This is a pretty interesting factor that I cannot underemphasize. Capital allocation is where mediocre management is distinguished from excellent management. The Board of Directors is allocating capital to repurchase shares, even in the $45 to $60 range. This is rather than putting it into research and development, into acquisitions or other possible investments that could produce a reasonable return. The message I read in the Statement of Cash Flows is that Pfizer has maxed out research and development, does not see an acquisition priced as favorably as the company is itself, and it is backing up the truck to buy back the company's stock.

Still, there is no guarantee this capital allocation decision is the proper one until after the fact. One area that it has not been allocating to is dividends. The Board has only grown the dividend by an average of 10.9% over the past five years, well below the average for Pfizer's peers. That extra R&D money had to come from somewhere and it came from the dividend. As rising dividends over time are a major source of return, knowing it was a sub-par repurchaser of stock in 1995 and 1996 and that it has not done so well on the dividend either leaves me unimpressed. The real upside in the Pfizer story is earnings, and those earnings have been discounted into the current valuation. Although share repurchases are picking up, I think that at the current price I would want confirmation that the company can grow at an above-average rate over the next few years before I would pile in, which probably means waiting a few more quarters. This goes along with Jeff's idea of looking at the stock again after we have the cornerstones of the portfolio in place.

Tomorrow, I will look at JOHNSON & JOHNSON (NYSE: JNJ).

TODAY'S NUMBERS 

                    Day   Month Year  History
        Drip:    +0.00%   0.00%  0.00% 0.00%
        S&P:     +0.00%   0.00%  0.00% 0.00%
        NASDAQ:  +0.00%   0.00%  0.00% 0.00%


        Rec'd   #    Security         In At      
       9/8/97   1      Intel         $94.69      

                          
                        Base: $700.00
                    Expenses: $ 55.50 (Moneypaper)
                   Purchases: See above
                        Cash: $549.10
                 Total Value: $652.00 apprx.

The portfolio began with $500 on July 28, 1997, adds $100 on the 15th of every month, and the goal is to have $150,000 by August of the year 2017.