We now know which stocks Warren Buffett's Berkshire Hathaway (BRK.A 0.55%) (BRK.B 0.49%) added to its portfolio in the third quarter. The giant conglomerate's regulatory filing to the U.S. Securities and Exchange Commission on Monday revealed that Buffett appears to be quite bullish on big pharma.
Berkshire's new positions in Q3 included four of the biggest drugmakers on the market: AbbVie (ABBV -0.77%), Bristol Myers Squibb (BMY -1.15%), Merck (MRK -1.09%), and Pfizer (PFE -0.61%). Here are three possible reasons why Buffett loaded up on big pharma stocks.
1. They're relative bargains
Although Warren Buffett isn't the diehard value investor he once was, he still likes to buy stocks at a good price. All of the big pharma stocks Berkshire bought in Q3 are relative bargains.
AbbVie, for example, trades at only a little over eight times expected earnings. Bristol Myers Squibb's forward earnings multiple is just a little higher than AbbVie's. Shares of both Merck and Pfizer trade at close to 12 times expected earnings. Those forward price-to-earnings multiples are even cheaper than Berkshire Hathaway's own forward P/E of a little under 17.
It makes sense to some extent why AbbVie is cheap. The company faces biosimilar competition in the U.S. for its top-selling drug Humira in 2023. Bristol Myers Squibb also will begin to compete against generic versions of blockbuster blood cancer drug Revlimid beginning in 2022. However, both drugmakers have newer drugs that should be growth drivers, particularly BMS.
2. They're cash cows
There's one thing you can count on with big pharma stocks -- strong, steady cash flow. That's exactly what Buffett and Berkshire will get with AbbVie, BMS, Merck, and Pfizer.
AbbVie ranks at the top of the group with operating cash flow of close to $16 billion over the last 12 months. BMS and Pfizer generated operating cash flow of $12.4 billion and $12.5 billion, respectively, during the same period. Merck wasn't too far behind with operating cash flow of $11 billion.
These operating cash flows pale in comparison to Berkshire's total of over $41 billion during the last 12 months. However, all four of the big drugmakers generate significantly more operating cash flow than Biogen and Teva, two other biopharmaceutical stocks in Berkshire's portfolio.
3. They provide diversification in a fast-growing sector
That leads us to the final reason why Berkshire probably bought shares of these four big pharmaceutical companies: They provide diversification for the conglomerate in the fast-growing healthcare sector. Other than the aforementioned Biogen and Teva, Berkshire owned positions in only two other healthcare stocks prior to the third quarter -- DaVita and Johnson & Johnson.
Healthcare accounts for nearly one-fifth of the U.S. gross domestic product. It's surprising that Berkshire didn't already have more exposure to the important sector.
Many observers (including yours truly) questioned Berkshire's investment in Biogen earlier this year. I suspect Buffett will regret that purchase if he doesn't already. Biogen's growth prospects are in jeopardy after a Food and Drug Administration advisory committee voted against Alzheimer's disease drug candidate aducanumab.
However, I think Buffett and Berkshire made smart moves with this latest foray into the biopharmaceutical industry. Bristol Myers Squibb should have great growth prospects thanks to a bevy of potential blockbusters picked up with its acquisition of Celgene last year. Merck appears to be in good shape with its juggernaut cancer immunotherapy Keytruda. Pfizer is set to return to solid growth now that its merger of the Upjohn business with Mylan is complete.
AbbVie probably won't deliver impressive growth anytime soon because of the coming challenges for Humira. However, the company should still generate decent total returns with its juicy dividend and continued momentum for multiple blood cancer and immunology drugs.
Overall, I think that loading up on big pharma stocks is a big step in the right direction for Berkshire -- and one that Buffett won't regret.