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Why Merck Is a Hot Stock

By Peter Stephens - Dec 18, 2013 at 8:41PM

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Keep your eye on this pharma.

Editor's Note: The forward P/E for the S&P 500 was incorrect in a previous version of this article. The Fool regrets the error.

With the S&P 500 trading at a forward P/E of almost 16.3  and U.S. economic data continuing to pick up, a great-value, low-beta stock with significant future potential could prove to be the hottest stock out there. One stock that fits that bill is Merck, which seems to offer a potent mix of great value and high quality, topped off with impressive future growth prospects. It trades at a forward P/E of just 13.9, well below the S&P 500's P/E of over 16.

This discount is vast: Merck currently trades at a 14.5% discount to the S&P 500 and appears to offer great value at a time when stocks offering such discounts appear to be rather thin on the ground.

Furthermore, it appears as though such a large discount is without merit -- Merck looks financially sound and with encouraging prospects and, as with many of its pharma peers, benefits from substantial barriers to entry in the form of patents.

Many investors (not Fools, of course) overlook patents, but they provide a great deal of revenue visibility and earnings stability. This means that major pharma players such as Merck are less likely to see profits substantially down over a three-year period, and this, in turn, provides investors with increased stability and more consistent returns over the long run.

The exception, of course, is where blockbuster drugs lose their patents and become targets for generic-drug manufacturers, thereby reducing margins significantly. If new drugs don't replace the old ones, it can lead to a significant fall in earnings, as Pfizer found in 2012. It lost $7.4 billion in revenue from just a small handful of drugs going off-patent, with nothing as adequate to take their place.

Now, though, Pfizer is adding to its pipeline and creating a far stronger list of drugs that are awaiting FDA approval. Although its pipeline may not be quite as strong as that of GlaxoSmithKline, which has invested heavily in previous years to avoid a so-called patent cliff, it is making clear progress. Furthermore, both companies are divesting various consumer-focused brands to focus on research and development, which should further strengthen their drug pipelines.

Merck's pipeline appears to be very encouraging, with 20 programs in phase 2 clinical trials, 13 in phase 3, and nine drugs under FDA review. Merck thus has options for when the current patents on its blockbuster drugs run out, and although the outcomes of drug trials and reviews are inherently uncertain, such a list of programs should mean revenue increases over the medium to long term.

Of course, with the S&P 500 continuing to tick ever higher as the Federal Reserve manages the tapering of its monthly asset purchase program, it could be that Fools are seeking out companies that may fall less than their peers. Merck's beta of 0.6 means that for every 1% fall in the S&P 500, Merck should (in theory) fall by just 0.6%, with the opposite being true if markets were to rise.

That could become increasingly relevant as the Fed makes more substantial inroads into the tapering of its monthly asset-purchase program in 2014. In short, Merck is going to be a stock to watch.

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Stocks Mentioned

Pfizer Inc. Stock Quote
Pfizer Inc.
$51.69 (1.47%) $0.75
Merck & Co., Inc. Stock Quote
Merck & Co., Inc.
$92.81 (0.32%) $0.30
GSK Stock Quote
$43.25 (-1.19%) $0.52

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