With a big mid-term election coming up on Tuesday, I figured I'd do a politically-themed post.
It seems the prominent view that gridlock is good for the stock market is one that continues to be held by big investors. In this weekend’s Barrons, the cover story indicates that a common theme now being echoed among "big money" investors is that gridlock is good for the stock market. This is a belief that many hold, but one which has been called into question by a recent study published in the Financial Analyst’s Journal.
Gridlock is considered to be the state of government where the Senate, House, and Presidency are not held by the same party. The thesis behind “gridlock is good” for the stock market is that fewer legislative changes will take place in this situation, which reduces economic uncertainty.
The popular press has mentioned the “gridlock is good” argument fairly consistently, it seems without the proper data to back it up. The study I mentioned provides evidence that a government controlled by the same party – what they call “political harmony” – has enjoyed higher equity returns with lower volatility than during periods of gridlock. "Harmony” returns have been from 22% higher for the smallest companies to 0.5% higher for the largest companies - versus periods of political gridlock.
Furthermore, the study shows that the smaller-company “premium,” where small cap stocks have historically provide higher annual returns than large cap stocks, occurs in periods of political harmony (up 27.03% versus 4.65% in gridlock), and that large-cap stocks have actually outperformed smaller ones during periods of gridlock by nearly 4% annually. These results are independent of monetary conditions that existed during these periods, so they are significant.
On the other hand, the study found that fixed-income returns and volatility were higher during periods of political gridlock. This was mainly the result of interest rate changes during these periods.
I find it fascinating when a long-held, ubiquitous belief is shown to be wrong. This illustrates why its important as an investor to know why we hold the beliefs that we use in making investment decisions. They could very well be unfounded, or worse yet, wrong.
We discuss a broad range of issues that are often investment-related, but not always so. We call it a 'thought blog'. Sagacious: Having or showing keen discernment, sound judgment, and farsightedness.
Investing Rationally
"Warranted beliefs are more stable and more reliable than emotions."
- Bill Miller, CFA
- Bill Miller, CFA
Biovail - A Value Trap?
I’ve got an idea today that could either be a great value or a value trap. This particular stock has a 3.2% dividend yield. Debt is 23% of total capital and is covered nearly ten times by operating income. Perhaps most compelling is its 18% free cash flow yield. That is, the free cash flow (operating cash flow minus capex) divided by the price is 18%. This means that if you bought the whole company in its current state, you’d be earnings 18% on your money each year. And in case that doesn't make you salivate, nearly 1/5 of its market value is in cash.
Biovail (BVF) is trading at its lowest P/E, price/sales, and price/cash flow multiples since 2001. Net profit margins have been volatile, so based on average net profit margins of the past five years I calculate the stock as trading (cash stripped out) at under 8 times earnings on expected revenues of $950 million for next year, which represents a 6% drop from this year. Based on the factors above, it looks like the stock could use some serious consideration.
But what is the market telling us about its future prospects? Using a discounted cash flow model and a high discount rate (due to its business risk), it appears the market is pricing Biovail as if owner earnings (earnings minus CapEx plus depreciation) are going to be cut in half in the near future. This is entirely possible, mind you, as its primary revenue generator, Wellbutrin, accounts for 38% of its sales and it may lose market exclusivity for that one sooner than expected. Yet the company does have other drugs in the pipeline that could replenish this $300 million shortfall within a reasonable amount of time.
Biovail takes successful existing drugs that have come off-patent and makes them better. These reformulations are provided 3 years of market exclusivity, so there is considerable operational risk here. The company continually needs to come up with new ideas in a cost effective manner to growth profitably. Results have been volatile – certainly not as predictable as a seller of razor blades.
This lack of predictability makes Biovail a risky holding if the time horizon is long-term. To buy Biovail is to believe that the company will innovate in the future as they have in the past – with more and more drugs. They’ll need an increasing number of products at least every 3 years to continually grow their revenue base. Certainly, they have no competitive advantage in each individual product beyond market exclusivity. Yet perhaps they have an advantage in oral drug delivery technologies they use in their reformulations.
In order to invest in Biovail, I would need a reasonably good understanding of how sustainable the advantages are, if any, in the technology that Biovail uses. To me, it doesn’t seem like controlled release, graded release, enhanced absorption, rapid absorption, taste masking and oral disintegration technologies would be that difficult to copy. If they are easy to copy, the company’s only strength is in its ability to take an old drug, improve it before everyone else and get it to market the quickest. In this case, it's hard to evaluate sustainability into the future.
On top of these considerations, the company is under investigation for insider trading, financial disclosure and reporting, as well as product marketing practices. Yet the numbers make Biovail one to keep an eye on.
Biovail (BVF) is trading at its lowest P/E, price/sales, and price/cash flow multiples since 2001. Net profit margins have been volatile, so based on average net profit margins of the past five years I calculate the stock as trading (cash stripped out) at under 8 times earnings on expected revenues of $950 million for next year, which represents a 6% drop from this year. Based on the factors above, it looks like the stock could use some serious consideration.
But what is the market telling us about its future prospects? Using a discounted cash flow model and a high discount rate (due to its business risk), it appears the market is pricing Biovail as if owner earnings (earnings minus CapEx plus depreciation) are going to be cut in half in the near future. This is entirely possible, mind you, as its primary revenue generator, Wellbutrin, accounts for 38% of its sales and it may lose market exclusivity for that one sooner than expected. Yet the company does have other drugs in the pipeline that could replenish this $300 million shortfall within a reasonable amount of time.
Biovail takes successful existing drugs that have come off-patent and makes them better. These reformulations are provided 3 years of market exclusivity, so there is considerable operational risk here. The company continually needs to come up with new ideas in a cost effective manner to growth profitably. Results have been volatile – certainly not as predictable as a seller of razor blades.
This lack of predictability makes Biovail a risky holding if the time horizon is long-term. To buy Biovail is to believe that the company will innovate in the future as they have in the past – with more and more drugs. They’ll need an increasing number of products at least every 3 years to continually grow their revenue base. Certainly, they have no competitive advantage in each individual product beyond market exclusivity. Yet perhaps they have an advantage in oral drug delivery technologies they use in their reformulations.
In order to invest in Biovail, I would need a reasonably good understanding of how sustainable the advantages are, if any, in the technology that Biovail uses. To me, it doesn’t seem like controlled release, graded release, enhanced absorption, rapid absorption, taste masking and oral disintegration technologies would be that difficult to copy. If they are easy to copy, the company’s only strength is in its ability to take an old drug, improve it before everyone else and get it to market the quickest. In this case, it's hard to evaluate sustainability into the future.
On top of these considerations, the company is under investigation for insider trading, financial disclosure and reporting, as well as product marketing practices. Yet the numbers make Biovail one to keep an eye on.
Companies Should be Viewed As Investment Conduits
We think that the best way to view a company is as an investment vehicle. This is what corporate management is paid to do – invest shareholder capital in areas where attractive investment returns are (hopefully) available.
At its base, a business invests capital in a collection of projects, products, or services and hopes to earn a return commensurate with the risk taken. It wants to earn a return on its invested capital – that is, equity and debt invested. And over time, the business will create wealth if it can earn above its cost of capital.
For a simple example, we’ll ignore taxes and consider a piece of real estate worth $1 million. Perhaps the buyer puts down 20% ($200k) of the purchase price, leaving $800k to be financed with debt at an 8% interest rate. So, the debt portion must earn enough in rent to pay costs plus an 8% (net of tax) payment to at least break even. That is, costs (maintenance, management, insurance, taxes, etc.) plus $64,000 to pay the principal and interest (P&I) on the loan. This is break-even on the debt portion.
The equity (20%) portion is a little trickier since it doesn’t actually have an explicit cost. Yet according to economic theory, this portion should be assigned an opportunity cost. For example, the opportunity forgone to invest in a similarly risky stock or bond that would earn 10%. Thus, this portion should earn costs plus 10% to earn an economically break-even return – $20,000 after costs.
In order to earn an excess economic return, returns must be greater than the weighted-average of these capital costs – [(.20x10%)+(.80x8%] = 8.4% after costs to break even in economic terms. So if the investment earns 10%, there is a 1.6% excess return (10%-8.4%). This is how economic wealth is created.
Many companies do not earn long run returns above their cost of capital, so how do they go on living? Certainly if it can’t pay its debts it should be bankrupt! Well, as I mentioned, the equity portion of capital does not really have an explicit cost, so a company can still cover its explicit debt costs while eroding the returns to equity.
Same thing in the real estate example. If it only earns 7% on the entire building after costs, it still has $70,000 to cover the $64,000 P&I. Ignoring principal payoff and appreciation, this leaves only $6,000 for the equity portion – a 3% return on the equity. If such a situation is expected to continue, this capital would be better employed in a money market account earning 5%. The exact same concept applies to publicly traded companies, albeit on a more complicated scale.
The bottom line is that we want a company to, say, borrow at 7% what it can invest at 15%, earning the “spread” of the investment return minus its cost of capital. This is, at its base, what every company is trying to do whether it sells steel, toilet paper, tax preparation, or owns real estate. Earning a return on its investments above the cost of the funds in the long run generates economic value for shareholders.
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