Since Philip Durell recommended Omnicare
Philip used a variety of quantitative and qualitative factors to identify this stock, but the general process is one anyone can learn. It's not a process we invented. Rather, we're simply borrowing the teachings of master investors such as Warren Buffett and Peter Lynch. By following in the footsteps of the great ones, we avoid the Wall Street hype and focus on what really works. That's how we found the easy 80% in Omnicare.
Understand the company
The first task when researching a stock is to figure out what the company does and how it makes money. By understanding the business, you'll be better able to evaluate the company's competitive position and potential risks. Even in cases when it seems obvious what a company does, it's worthwhile to do your research.
For instance, everyone knows that Harley Davidson
Omnicare, on the other hand, distributes pharmaceuticals to nursing homes. The company purchases drugs in bulk, repackages them according to an individual's prescription, checks for potential drug interactions, and delivers them. The business is one with recurring revenues since nursing homes continually need medications for their patients. Plus, demographics ensure this is a growth industry -- as baby boomers age, they will eventually require such services.
Understand the competitive position
To determine whether a company is likely to prosper over the long term, you need to understand its competitive position. Identify the competition and the factors that will keep that competition at bay. So for Coke
Omnicare, on the other hand, is the leader in a fragmented market. When Inside Value initially recommended the stock, it had a 37% market share. But after the purchase of a major competitor, NeighborCare, it now controls almost half the market, significantly more than the No. 2 and 3 players, Kindred Heathcare
Furthermore, Omnicare has both patient databases and databases that assist physicians in their prescriptions by providing clinical information about the efficacy of various medications for the elderly. Potential competitors cannot easily reproduce these databases, so they, too, act as a major barrier to competition.
Understand the risks
Any investment should include analysis of both the upside and potential hurdles. Understanding the risks not only helps you determine what a company's worth, but also enables you to identify problems before their true impact is felt by the company. For instance, if you consider Harley Davidson's consumer credit operations as a risk, an increase in consumer defaults could signal that the company is likely to have problems down the road.
With Omnicare, Philip identified his primary risks. First, he was concerned with the debt load associated with the NeighborCare acquisition, though he thought that Omnicare's free cash flow would be sufficient to handle it. Second, he was worried about the challenges of integrating two large companies and whether the potential cost savings would be fully realized. Finally, he was worried about the slowly increasing number of low-margin Medicaid patients and the potential for increased regulation in the drug industry.
The NeighborCare acquisition just closed in August, so the first two issues are likely to be decided over the next couple of years. The Medicaid and regulation issues continue to be long-term risks to Omnicare, while also providing a competitive advantage insofar as they act as barriers to competition.
Calculate the value
The final step in our process involves calculating the value of the company. Regardless of how great a company is, we only recommend it if it's a true bargain -- if you can buy shares of the company for substantially less than their fair value. This not only reduces the risk of losing money, but also provides the opportunity for extraordinarily high returns.
In the case of Omnicare, Philip calculated the intrinsic value of the company's shares somewhere between $41 and $51. At the time, however, Wall Street was throwing one of its periodic hissy fits after the company had missed earnings estimates. Consequently, shares were trading for less than $30. Philip recognized the disconnect between share price and the fair value and recommended the purchase because he "fully believed that the share price could double within three years." Less than a year later, the shares are already close to achieving that prediction.
Now, not all Inside Value picks have done so well, but using these methods, our overall portfolio has bested the market by six percentage points in our first year. Thus, I'd recommend these techniques to any investor. If you're new to these investing techniques and want to see how we apply them to find undervalued stocks or just want to see the bargains we find, we are offering a free one-month trial to Inside Value. You will be able to read every newsletter from the past year, including Philip's original Omnicare recommendation. Plus, September's newsletter reexamines every pick from the last year, and highlights our top recommendations for new money now. Click here to join thousands of subscribers beating the market using the techniques master investors have used for decades.
Richard Gibbons , a member of the Inside Value team, believes that people who don't have enough data for statistical significance fall back on case studies to support their arguments. He does not own shares in any of the companies discussed in this article. The Motley Fool has adisclosure policy.