RTCrawford’s Weblog

Never let it be said that, in this journal of my investing life, I was not prepared to describe my mistakes.

I am, in fact, thinking of Pfizer, which I purchased at $25.46 and $22.96 on March 9, 2007 and February 26, 2008, respectively, for an average price of $24.00.  Today, the stock is selling for $17.39 — down around 28%.  At the time, it seemed a reasonable purchase (they all do), selling cheaply based on discounted cash flows.

The problem was that, while I teach healthcare management, that doesn’t make me qualified to assess the strength of pharmaceutical products or their pipeline of compounds undergoing research and development.

In short, this stock should have gone into my Too-Hard pile … but it didn’t.  In fact, even if my resume included the earned-degrees PharmD and bio-physics Ph.d., I doubt pharmaceutical firms creating patent-protected medications would ever emerge from the Too-Hard box.

Today, the stock is undervalued based on DCF (Discounted Cash Flows).  With Lipitor’s expiration looming and the pipeline unimpressive to the market, DCF indicates the stock is undervalued by more than 60% — using a starting value of free cash flows of $15.3 billion, a free cash growth rate of 12.8% (the median of running three- and five-year medians over the past decade), a 5% growth rate for the second decade, a 15% present-value discount rate, and the current $95.56 billion in shareholder’s equity as the continuing value).

Even if basing DCF on Owner’s Earnings, rather than Free Cash Flows, and estimating future growth using sustainable ROE (i.e., normal ROE with dividends subtracted) the stock is selling at a 37.2% discount.

Lengthy Educational Aside That Delays Admission of Dufus Error In Judgment.

At this point, I should stop and, for the sake of explanation and reader education, describe something that hasn’t been put forward with prior postings — this education thing is, after all, one of the reasons for this blog (kind of a “look what I learned at camp” exercise).  Specifically, I should explain the concept of sustainable ROE (we will return to PFE as a mistake soon enough).

First, Return on Equity is defined by Investopedia as:

Return on Equity = Net Income/Shareholder’s Equity

Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder’s equity does not include preferred shares.

ROE can be broken out based on three and five measures, using the Dupont Breakdown. For the three-item version, we have:

Net Income/Sales
Sales/Total Assets
Total Assets/Equity

Note that the first two items are the components of Return on Assets, where Net Income/Sales is the company’s Profit Margin and Sales/Total Assets is the Asset Turnover rate. The third item, Total Assets/Equity, represents a measure of the company’s debt and is known as the Equity Multiplier. This means the difference between Return on Assets (ROA) and Return on Equity (ROE) is the multiplier effect of debt.

For Pfizer, we get:

Note that, when I first purchased the stock in 2007, debt was declining and the other two items were stable — even though the Asset Turnover measure was down from 2000.  Since then, the Equity Multiplier has increased while Asset Turnover has dropped yet again.

The other breakdown of ROE involves five items:

Tax Burden = Net_Income/Earnings Before Taxes

Interest Burden = Earnings_Before Taxes/Operating Income

Operating Profit = Operating Income/Revenue

Asset Turnover = Revenue/Total Assets

Leverage Ratio = Total Assets/Total Equity

Note that the Leverage Ratio line from this chart and the Equity Multiplier from the previous chart are the same, as is the Asset Turnover line.  To make this chart an even more confusing jumble of lines, I’ve added a sixth line for the ROE.

Now, lets turn to the calculation of the Sustainable Growth Rate, which is the rate of growth the company can, theoretically, generate without taking on new debt, securing  other capital financing, or delving into savings.  Let’s start with the general spreadsheet:

I should note that all dollar figures are in millions.

The portion of the spreadsheet that pertains to Sustainable Growth is this part:

The first thing we need to do is to determine the percentage of free cash flows not distributed as dividends.  The company, after all, can only deploy the cash it has available for deployment (before taxes).  So, we use the percent of free cash not distributed as dividends:

I’ve provided the calculations, which reads:  =IF(B17=0,0,1+(B16/B17)).  This is an if-then statement, where the first part forces a zero response if the denominator in the subsequent equation is zero.  The meat of the equation is:  1+(B16/B17).  This has the effect of identifying the percentage dividends paid out of free cash, which is then subtracted from 1 (100%).  In other words, this is the percentage of Free Cash Flows left over after dividends are paid.

Because dividends are taken from the Statement of Cash Flows, where dividends paid are always negative numbers, I add the negative percentage of dividends divided by free cash flows to 1 (100%).    I could have calculated this as  1-(-1*(B16/B17)), but that would have been less elegant (which is computer-geek-speak for “needlessly complex”).

The rest of this is really very straight forward.

Specifically, just multiply ROE by the percent of free cash retained by the company.

By the way, you can do the same for ROA, but, instead of Sustainable ROE, this is known as the Internal Growth Rate.  Why?  Well, recall that the difference between ROA and ROE is the equity multiplier … i.e., debt … and debt represents external capital financing.

Note that, for companies with absolutely no debt, ROE and ROA will be the same.  AND, for companies that pay no dividends, sustainable growth will be no different than ROE, just as internal growth will be no different than ROA when no dividends are paid.  In the case of Pfizer, there is a difference for both:

Recognizing this distinction between ROE and ROA, on the one hand, and Sustainable Growth and Internal Growth, on the other hand, is important.  It implies that ROA and ROE are important measures when trying to determine the benefits accruing to the stockholder.  But, if viewing ROA and ROE from the perspective of the company, Sustainable and Internal Growth are the better measures.

Personally, I am more concerned with the company’s future growth than with the dividends paid to me as the stockholder.  If the company can grow and generate results at rates greater than I can produce with other investments, that is my preference.

Indeed, most companies can more easily generate superior results because they have a headstart of between 15% and 35% (the tax hit I confront when selling the stock or receiving dividends).  In fact, the company’s head start is even more pronounced  because it can invest profits toward future growth before paying taxes on those profits.  Add to this the miracle of compounding, and that head start is so pronounced that I stand a snowball’s chance in hell if hoping to easily find a superior investment alternative when the market is fairly valued or over valued.  It is only if the company can not generate productive returns at rates exceeding the norm (net of my tax hit) that paying a dividend benefits me, as the stockholder.

This is a recognition that appears to befuddle many investors.  On the online message boards, someone is bound to argue that management should pay a dividend or increase the dividend or repurchase shares as a way to improve the stock’s price.  Rarely do they consider the tax implications of their urgings or the impact of share repurchases on the company’s profitability and growth prospects over time.

Even if I plan to sell the stock in a year or two, I want the company to think and plan for the long-term — to act as though none of its stockholders will ever sell.  Why?  Eventually, the market tends to give a premium value to those companies possessing substantial promise for decades to come, while, conversely, the market discounts the value of companies that manage their investments as if they are to be sold tomorrow.

This is different from the conventional wisdom, of course, but think about the price demanded for the strongest firms — those with the most consistent returns and strongest reputations.  The price of JNJ may decline short-term if posting less than consensus results, but the price is unlikely to tank to the same degree as for firms with less-reliable or suspect prospects.

On the other hand, it may be imagined that the stock will sell at a higher price if the market anticipates that the company is for sale — expecting that an acquiring firm will pay a premium of around 20% or more.  That 20%, however, is a pittance compared to the compounded growth that quality companies can generate when reinvesting profits to the benefit of the owners.  It is only when the company is unable to do this and has an excess of cash (more than it can productively use) that paying a dividend or repurchasing shares makes sense for the owner.

So, when I decide to sell a stock, I want the market to pay an exceedingly dear premium for my wisdom in selecting excellence, and I want to sell at a profit sufficient to compensate me for the tax hit and market risk.  Selling, therefore, at a 10% or 15% profit falls short of that mark, and, if the company is bought out at a 20% premium, that 20% is barely enough to compensate me as the owner, after factoring in the capital gains taxes, the market risks, and my subsequent obligation of finding another investment that can generate an adequate and reliable return on my investment.  Great investment ideas are not so plentiful that being bought out for a 20% gain makes we weep with joy.

Perhaps a different perspective will prove helpful.  If inflation is expected to run at around 4% or 5% over the coming decade (due to increased deficit spending by government) and yearly market risk comes in at 6.8 percent, my minimum required rate of return is around 12%.  Add to this the risks associated with opportunity costs (the risk that I won’t be able to find another opportunity), and that increases my required rate of return to somewhere between 15% and 17%, depending on whether the market under-, fairly-, or over-valued.  If receiving a 20% premium over the current market price for the stock (the price at which I could sell regardless of whether the company is bought by an acquiring firm), my gain is just 17% after taxes (assuming a 15% capital gains tax).

In other words, my required rate and the return received are the same — making me agnostic on the acquisition.  If my acquired company is truly excellent, my agnosticism turns to angst — which is how I felt when NOV acquired Grant Pride Co several years ago.  Grant (which I owned) was a wonderful company (the financial ratios and performance were clear on this), while NOV was bigger but not nearly as impressive.  To be fair, NOV paid a 30% premium for Grant, but Grant was so good that I couldn’t help wonder whether I was being under compensated.  And, when NOV’s stock shot-up after the deal went through, my suspicions seemed confirmed.  Pleasantly, the deal was a combination of cash and stock, so I benefited from my newly-received NOV shares (a lucky break that had nothing to do with my skill as an investor).

By the way, all of this is different from conventional value-investing, where the lion-share of price appreciation is derived from having bought at a discount on the front end.  Buffett, however, seems to hold this same perspective — given his penchant for buying and holding long-term, preferring companies with well-defined and defensible moats, and his willingness to pay a fair price for an excellent company.

Back to My Mistake With Pfizer

Of course, I started this aside (tangent discussion above) just to note that DCF analysis can be based on other measures than discounting free cash flows, only.  This is something I learned from Bill Ellard, who I met on the AEO Yahoo Finance! board.  Bill didn’t suggest this specific approach (for good or ill, I came up with the idea of using owner’s earnings and the concept of Sustainable Growth and Internal Growth were pulled from an old business school text).  Nevertheless, it is interesting to note that Pfizer’s ROE and ROA have been declining over the past decade, and that the portion redeployable by the company has so eaten into the results that fostering future growth from such meager returns is questionable … sort of.

In the case of Pfizer, the company has a reasonable cash stockpile from prior years:

This indicates that 28 cents per share is in cash, versus a little less than 80 cents paid out in dividends.  This means that dividends are primarily paid out of free cash flows.  This is a positive, in that the company is not depleting accumulated cash to pay dividends (the dividend would be suspect if that were the case), but it does raise concerns for dividend sustainability in a post-Lipitor world.  The company, however, has been taking steps to diversify its product mix through mergers and acquisitions, even if internally-generated growth through its new-products pipeline has been uncertain.

And that is why my earlier purchase of Pfizer was a mistake.  Simply put, I didn’t know what I was buying when it came to the research and development pipeline.  Yes, the company is strong financially.  Yes, the company’s history is impressive.  Yes, it has sufficient size to pay a premium to purchase competitors and sustain itself while its researchers search for the next break-through.  But, at the end of the day, pharmaceutical companies are like financial institutions.  The investor is gambling on success without sufficient information on which to estimate the company’s long-term prospects.

Now, this is really interesting on a number of fronts.

Buffett has argued that he wants to have an excellent feel for where the company will be in 20 years.  For pharmaceutical firms, this is not possible.  Patent protection lasts 20 years, and, since the company must file for patent protection when first identifying a new chemical compound for testing, by the time lab research, animal testing, human clinical trials, and the FDA approval process are completed, the viable life of the resultant product is just 5 years or less.

Buffett, however, owns Pfizer.  Huh?  Warren must have a crystal ball.

Moreover, as noted in earlier postings (especially, one generated for Joe Ponzio’s FWallStreet), I argued that investing in financial firms is speculative because the investor has no means of judging the portfolio of loans and investments undertaken by financial firms (banks, investment banks, and insurance).  There simply isn’t sufficient granularity to make an informed investment decision.  This isn’t just my opinion, no less than Benjamin Graham agreed in, both, Security Analysis and the Intelligent Investor, and the consultant-authors of Valuation at McKinsey and Company have found no recent approach to overcome this problem.  Consequently, I have never invested in a financial firm.

Well, the same problem exists with pharmaceutical companies, because the investor has no means of determining the future prospects of R&D initiatives.  Think about all of the promising “blockbusters” that have failed to meet their targeted end-points during stage III trials.  Think of those that have been denied FDA approval.  And think of those which have earned blackbox warnings after FDA approval.  Terrorist attacks and natural disasters do not show up with the same frequency.  We’ve had fewer than 5 acts of terrorism over the last 20 years, average 11 hurricanes yearly (most fail to generate catastrophic claims at category 4 or 5), and there have been fewer than five earthquakes in the US over the past two decades, but the same may not be said of the hoped-for “blockbusters” than weren’t.

Now, this is appreciably different from the generics — which piggy-back on the brilliance of others (and they will soon be the beneficiaries of Pfizer’s Lipitor).  Indeed, we are all the beneficiaries of pharma’s efforts, but, as an individual investor, I’m pleased that I plunked down just $2 thousand on Pfizer (a relatively small percentage), and, as a value investor, I won’t be making this mistake in the future.  Pharma, candidly, can experiment on another’s dime.

Of course, you may argue that with R&D-intensive companies increased risk produces increased rewards.  This, however, is not an immutable law of physics.  Risk and reward are not balanced if playing blackjack at the Sands in Vegas.  The rewards are decidedly insufficient to support playing Russian Roulette (even if doing so in Hawaii) or having unprotected coitus with a partner of suspect affections.  And there is nothing about pharmaceutical R&D that guarantees a favorable balance between risk and reward for the investor.  In fact, the buying and selling of equities is, in most cases, a zero-sum-game, where one side pays too much or buys at a bargain and the other side receives a premium on the sale or sells prematurely.

Finally, I would be remiss if not noting that, after passage of healthcare reform legislation, Pharma is one of the few groups potentially benefiting from its enactment.  In fact, Pharma has benefited from the no-negotiations and anti-reimportation policies of the federal government (in the US).  Some have argued that this is a mistake, but, given the speculative and unreliable aspects of generating novel therapeutics, both make abundant good sense to me.  Opponents of both policies should be asked how many medical breakthroughs they have produced in their working careers and impolitely told to “shut up” if the number is zero.

For me, however, investing is not gambling; otherwise, my wife would never allow it.  It is about buying fractional ownership of real companies when they are selling at a discount, and selling when the buyer is prepared to pay handsomely.  With Pfizer, I violated that tenet on the front-end, and, unable to value the company today, the decision to sell is equally difficult.  If unable to value a company, the investor can be taken when buying AND selling and, given the dilutive effects of inflation during the interim, can be taken while holding a stock he hasn’t valued with reasonable accuracy.