Last week, I shared with you some of my Motley Fool Inside Value interview with one of my favorite contrarian value investors, David Dreman. As promised, this week Dreman offers his insights on specific stocks and industries that he believes will perform well over the next five to 10 years.
I asked Dreman to recommend just one stock from his fund portfolio to hold for the next five to 10 years and tell us why. I got more than I asked for -- a lot more!
"Well, I never do that because I am never right. You know, what looks like your best stock at a moment in time may very well be your worst stock. So I will recommend a handful. I think that your readers won't be disappointed with a Fannie Mae (NYSE:FNM), an Altria (NYSE:MO), or a good oil company like ConocoPhillips (NYSE:COP). I also think the drug industry is one that is pretty undervalued today."
I, also, think the pharmaceutical industry is undervalued and claims that "the blockbuster model is dead" are somewhat premature. I think GlaxoSmithKline (NYSE:GSK) and Pfizer (NYSE:PFE) have excellent R&D and very good medium-term pipelines and will do well despite large blockbusters coming off patent. Because the Scudder-Dreman fund holds a small amount of Merck (NYSE:MRK), I asked Dreman what he thought of the withdrawal of arthritis drug Vioxx.
On Merck
"The company is enormously strong financially. The real problem for Merck at this point is just how big will the Vioxx class actions be? Nobody can answer that. Judging by companies (such as Wyeth (NYSE:WYE))in the past, it has been pretty universal, and none of these companies has ever gone out of business. My bet would be that Merck won't go out of business. They have got about $750 million of liability insurance.
"The other worry is that they don't have a strong product line, but a lot of companies in the drug industry don't at this point in time. That is something that changes with time. It seems that research dollars are random not only between companies, but within a company. Sometimes you get quite a number of drugs coming out that are blockbusters. Other times the research seems to be barren. But over time it has worked well. More and more, I think in the health-care industry, it is being recognized that good drugs are keeping people out of hospitals, even if they are pricey. They are far less expensive than staying in a hospital. Merck is going to have some tough sailing ahead of it, but if I were to bet on it, I think it is a stock that -- if people are not too frightened -- is something that can be held over time. It yields 5.4% today. I think the dividend is probably good for a while and maybe much better than we are thinking.
"One of the things we found about under- or over-reaction is that when there is bad news, the press seems to take it to the worst case, as do the analysts. So it is never quite as bad as they make out."
On Fannie Mae
"Turning to Fannie Mae, that is a very different story. On the whole, that is political battle. The current administration doesn't like government-sponsored enterprises. Nor does the most popular business journal in the country. They have been lobbying against the companies for at least three or four years, but there was nothing better than to get a hold of this report, the OFHEO report, which said that they simply had mismanaged -- or they had actually fixed their reserves to increase earnings so they could get their bonuses.
"Then there was another. I guess the other part of this is the director of OFHEO said it was black and white that (Fannie Mae's) accounting under FAS 133 wasn't accounting properly for derivatives. Then there was a major, as we know, hullabaloo on that. The bottom line is that they were hard-hit and (the) stock was knocked down quite a bit in late September.
"What happened, though, is that when it went before Congress or the House, the head of the committee was very anti-GSEs, but the entire committee was pretty pro-GSE. And rather than being stampeded, they -- Democrats and Republicans alike -- said they needed more time. In any case, Congress wants more facts. To sort of compound the problem here, the head of the SEC said that the accounting that OFHEO said was black and white is not black and white."
Note: Wednesday, the SEC's senior accountant ruled that Fannie's derivative accounting was not in accordance with FAS 133 and recommended it stop the practice and restate 2001-2004 earnings by $9 billion. The SEC did not say Fannie violated the rule deliberately to inflate earnings.
"So it looks like it is more of a political battle than anything else. There is no question that Fannie Mae has been somewhat arrogant in its treatment of OFHEO, and there is bad blood there, but there is also very -- there is little question that this is a really very cheap stock. It has been around since the '30s. It has never had any serious problems with accounting, so it seems to me that if the stocks are -- we are talking about Freddie (Mac) and Fannie together -- they are roughly eight times earnings. Growth is probably in the 8%-10% range down. It will probably accelerate over time."
The tobacco industry
"The whole tobacco industry has had an enormous change in the litigation against it. There are two types of damages: There are the damages for loss of job, medical, and so forth, and there are what they call punitive damages. In the State Farm case (overturning a damage award against the insurer), the punitive damages might have been 100:1 to the other damages. The Supreme Court said that that was far too high: It should be no more than single-digit numbers or roughly 9:1, and even then the plaintiff would have to prove why they were getting such a high damage reward.
"That had a major effect on tobacco. If you recall, there used to be $100 million lawsuits ... and (in California) I think there was one that went up to a billion dollars for one smoker. Those cases were based on the fact that the compensatory damages or the damages for the loss of work, loss of medical, cost of medical, and so forth, were pretty low, but the punitive damages could be as high as 1,000:1.
"Now the Supreme Court decision has cut the legs out of the legislation against the tobacco companies because now if it is 9:1, the average smoking case is about $300,000 to $400,000 in compensatory damages. So if you take even a 10:1 or a 9:1 ratio, it would be about $2.7 million on a $300,000 award. That would be maximum punitive damages allowed. Now, a trial lawyer usually gets about a third of that. Well, his costs are $1.2 million. He is not going to make any money on these cases anymore.
"There are a few class actions going on now that we think will be settled in favor of the tobacco and cigarette companies. But tobacco litigation looks like it is going to be much less than it has ever been in the past.
"So that gives these companies a whole new risk profile. Altria, for example, analysts estimate -- and we in our own calculations come close to these figures -- (to be worth) $80-$85 a share, and the stock is trading at roughly half of that. (It has since increased.) So we think that there is a lot of potential in these companies, but they will be somewhat volatile given any bad news."
To sum up: If you are feeling a little contrarian this holiday season and want three stocks you can buy and forget about for the next five to 10 years, Dreman recommends Fannie Mae, Altria, and ConocoPhillips. He also likes the pharmaceutical, tobacco, and oil industries for potentially undervalued companies.
To find more undervalued stock or read the whole Dreman interview, I invite you to take advantage of a 30-day, free trial to Motley Fool Inside Value.
Philip Durell owns shares of GlaxoSmithKline, and his wife owns shares of Fannie Mae.
