If your feet are feeling a bit frosty today, it's because hell has surely frozen over. Your friendly neighborhood Rule Breakers biotech analyst is making an appearance in value-land. No, I have not seen the light and sworn off speculative moon shots in favor of stodgy old large caps. Nothing quite that drastic. What I am doing is putting forth the idea that value investors may want to take a look at the drug industry while searching for dirt-cheap stocks.
The case for drug companies
I'm not the only proponent of the drug industry at the Fool. Looking at investing in this sector is actually an idea that The Admiral himself put forth last November when he said he was interested in large pharmaceuticals, particularly GlaxoSmithKline (NYSE:GSK) and Pfizer (NYSE:PFE). GSK has jumped a bit since that piece, and Pfizer is up 9% since Philip made it an official Inside Value recommendation three months later.
I explored that exact same group just two months ago when I wrote Is Big Pharma a Bargain? Compared to the types of multiples seen over the past decade, the pharma giants are certainly a lot cheaper than they've been in a long time. Maybe not enough to scream "BUY, BUY, BUY" but they're up on the radar of possibilities. And it's pretty clear in that article that I also like Pfizer.
Despite coming from opposite ends of the investing spectrum, the growth guy and the value guy have quite a bit in common.
I like drug companies because they can be superb long-term investments. There are a lot of reasons why value investors would want to own big pharmas if the right price came along. These companies are industry leaders, and they have strong balance sheets, long histories of earnings growth and increasing dividend payments, fat profit margins, high barriers to entry, and favorable demographic trends. Taken together, that's a recipe for a successful company for the long haul. If you agree those are winning components, then shocking as it might be, the biotech industry might have some companies that interest you.
I understand that aside from the dot-com world, biotech is probably the last place a value investor looks for ideas -- not unreasonable given its reputation for sky-high valuations and tremendous risk. Rich stocks and shaky business models don't jibe with capital preservation and buying companies for 50 cents on the dollar.
Still with me?
Getting biotech's volatile reputation out of the way, there are more than 300 public biotech companies to examine. Avoid those that are unprofitable and resting their fortunes on a single unproven drug and look for the best of the best. This cream of the crop consists of large, successful companies that are so similar to big pharma as to be nearly indistinguishable. If you agree with the above case for pharmas, then the big bios should also be up for consideration.
The industry leaders in biotech, and by this I mean companies like Amgen (NASDAQ:AMGN), BiogenIDEC (NASDAQ:BIIB), Genzyme (NASDAQ:GENZ), and MedImmune (NASDAQ:MEDI), have a heck of a lot in common with the large pharmaceutical companies: revenues in the billions with fat profit margins, moats around the business with entrenched drugs, deep drug pipelines, strong balance sheets, and terrific leadership.
In addition to these familiar names, there are a significant number of smaller, though still profitable, companies to take a gander at. For example one of these is QLT (NASDAQ:QLTI), which at a forward P/E in the upper teens, is a tasty morsel given its robust growth. These biotechs, though small, offer the same solid fundamentals as the industry leaders.
Take bio biotech over big pharma
As you can see with the successful biotechs, the same themes are in play as with the large pharmas, except in some regards the biotechs have advantages over the pharmas that make them even more compelling.
An example of this is the issue of intellectual property. When a drug goes off patent, other drug manufacturers can apply to the FDA to sell generic versions. This dramatically erodes sales of the branded product and is a significant problem for big pharma, as the company must make up that revenue from other sources.
Right now, a biotech company does not face such a threat to its product portfolio. These products are a lot more complicated to manufacture than the pills sold by big pharma. It is not even certain as to whether carbon copy generics of these drugs can even be made. Ever. Because of this, right now there are no procedures in place at the FDA to even approve generic biologic drugs. As long as this remains the case, the lack of a generic threat to product revenue gives biotechs lasting earnings power from current drugs that big pharma doesn't have.
Thus, while Pfizer will inevitably lose drugs like Lipitor and Viagra, Amgen can keep on selling Enbrel and Genzyme can keep on selling Cerezyme. Over time that gives a big edge to biotechs on the return on R&D investment. I see that as an important structural advantage.
I'm not saying you should buy the big biotechs right now. I think in general, they're too expensive, even though one time I did let a fat pitch go right down the middle of the plate. But that's OK. It may take awhile, but another biotech will show up at a discount to intrinsic value and I can do like the folks at Inside Value and buy it at 50 cents on the dollar.
For additional articles on the biotech industry, see:
- Do Good Drugs Guarantee Investment Success?
- The Best Company I've Never Owned
- After the Crash, Is Biogen IDEC a Buy?
- From Rags to Riches
Motley Fool Rule Breakers biotech analystCharly Travers owns shares of QLT. The Motley Fool has adisclosure policy.
