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  1. Home
  2. / Investing
  3. / Healthcare

Just Say No to Drugmakers

These big-cap names are ridiculously overvalued.
By TIM MELVIN Oct 21, 2013 | 05:00 PM EDT
Stocks quotes in this article: MRK, BMY, PFE, JNJ, LLY

It seems that we have finally set the Washington silliness aside for at least a few months. We will be revisiting all of this again earlier next year but, for now, at least we can stop talking about politicians all day. I actually heard the talking heads discussing actual companies and stock price movements this morning instead of John Boehner's tan and Harry Reid's antics. I even heard talk of taper once again, so perhaps the world and markets are going to drift back toward some sort of normalcy for a bit.

I spent part of the weekend at the beach communing with the dolphins and pelicans while catching up on the news of the week. One of the articles I found interesting was the semiannual report from Barron's on what the big money managers are thinking and doing right now. These folks are bullish in the aftermath of the budget fuss. Eighty percent of those surveyed say they think that U.S. equities will be the best-performing asset class in the next 12 months. A shocking 89% think that large-cap U.S. stocks will continue to rise over the next year. This in spite of the fact that 79% think the economy will grow by 2.5% or less and 85% think the stock market is either fairly valued or overvalued. The leap of faith here seems to be that corporate profits will grow faster than the economy and the Fed will remain accommodative. I have no knowledge of likely central bank actions but I find the idea of higher earnings and multiple expansion a bit much to buy now.

I use a model that uses current and historical earnings, revenues, cash flows and asset values to come up with a rough estimate of the intrinsic value of every stock in my portfolio. It gives me some idea of the fair value of a particular company and establishes a point where I might want to consider selling all or part of my position. After reading the latest bullish big money report, I checked some of the blue-chip, large-cap names to see where we stood in terms of fair value and current pricing. My take is that the large-cap stocks, especially the dividend payers that have seen yield-chasing, are not mildly overvalued. They are ridiculously so at current levels.

Let's look at some of the drug stocks that have been income investor favorites. Merck (MRK) has been a dividend darling for most of my career and right now yields 3.7%. Merck is a great company but I can't come up with a fair value number for the stock any higher than $28 a share. If I abandon all my principles and use the estimates for next year, I still cannot get over $34. The stock currently fetches more than $46 a share. To take a more traditional look you are paying more than 25x current and almost 14x the optimistic estimates for a company that will grow by less than 5% annually for the next several years.

It is even worse with the shares of longtime income favorite Bristol-Myers (BMY). If I stretch my numbers to the absolute limits, I can get to $17 a share. If I use the highly accurate Wall Street estimates, I can get to about $21. The stock is $49 a share and sports an earnings multiple of 60x current and 25x the forward estimates. The yield is just 2.9%.Revenus growth for the past five years is less than 3% annually and I believe they will be hard-pressed to stay at that tepid level for the next few years. Profit growth will be in the mid- to high-single digits at best. Bristol-Myers is also a very good company but the stock looks to be a lousy buy at this valuation.

It doesn't get any better for the other large drug companies. Pfizer (PFE) has a fair value of just $19 compared to a current price of about $30. Johnson & Johnson (JNJ) trades above $90 but my calculations assign a fair value of $51. Eli Lilly (LLY) has been falling of late but the $49 stock price is still above the $47 fair value number my model shows. The large-cap drug companies shave seen yield-chasing and indiscriminate exchange-trade fund and index-buying push their share prices well above any reasonable calculation of the value of the underlying business.

Going by the numbers investors should definitely say no to drugmakers at these levels.

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At the time of publication, Melvin had no positions in the stocks mentioned.

TAGS: Investing | U.S. Equity | Healthcare

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