Yes, but not in the way you think
Ready for blast off?
In 1997, heart disease was the leading cause of death in the US, killing over 700,000 Americans annually. It was a powerful backdrop for Pfizer launching Lipitor, a strong statin shown to reduce the risk of cardiovascular events for patients at risk.
The following year, Pfizer launched Viagra for erectile dysfunction, a new market opportunity affecting around half of men over 65. As the sales growth and market opportunity for Lipitor and Viagra captured the market’s attention (and imagination), the share price rose to stand at 50x forecast earnings by April 1998.
Fast forward to June 2000 when Pfizer bought Lipitor co-developer Warner Lambert for $90bn, taking its market cap above $300bn.
Spinning a yarn
I imagine portfolio managers holding the stock back then might have justified the high valuation by explaining what a wonderful business Pfizer was with a diversified drug portfolio each enjoying a huge total addressable market (TAM).
Throw in annuity income from drugs that patients take forever with high gross margins above 80% and a return on equity topping 40% and you have a cracking forever stock story.
All true.
Except 50x earnings means an expected earnings yield of only 2%. So if earnings do not grow beyond the one-year forecast and the company pays out all these earnings as dividends (which none do), you’d only receive a 2% return a year.
To achieve any kind of decent return at that lowly earnings yield requires two more variables – the fancy earnings growth to materialise for five years or more and these earnings to continue to be highly rated. Should either not happen, the shares will fall and more than wipe out the paltry earnings yield.
Decline and fall
So what happened with Pfizer?
Well, if you bought the shares in April 1998, before Lipitor generated more than $130bn of sales and before their Covid-19 drug Cominarty generated a further $95bn, you would be pretty upset.
Bloomberg tells me your total return would be minus 26% over 28 years.
Had you bought in June 2000 after the excitement of the additional revenue and pipeline acquired from the Warner Lambert acquisition, you’d be down 44%
But how can this be when Pfizer has grown earnings per share over this period?
An expensive story
The main reason is that investors overpaid for ‘the story’. The maths of overpaying for growth and quality can be very destructive to your wealth, as we’ve repeatedly seen in recent years.
Stories are about the past, but it’s the future that kills you. Forecasting growth over five years is an impossible task and the growth rate usually falters for some unexpected reason at some point. When it does, the de-rating can often be worse than feared.
In 2008 we had the global financial crisis where you might have thought a pharma company with a drug preventing heart attacks was a safe place to hide.
Sadly it wasn’t. When the market bottomed in 2009, Pfizer was valued at just 6x earnings, leaving an April 1998 investor down 80%. And that’s despite forecast earnings trebling in the decade to 2009.
Bad decisions, bad habits
The second reason is poor capital allocation. When Pfizer acquired Warner Lambert, it paid around 50x earnings, almost doubling the number of shares in issue – all this while Simvastatin, Lipitor’s largest competitor at the time, was about to go off patent.
Pfizer has continued to do deals, spending $100bn on acquisitions since 2016. Unfortunately, they’ve not had much return on this investment since then – operating cash flow was $16bn in 2016 and was only $11.7bn last year.
Not that the company chiefs were that bothered. In 2016 the then CEO enjoyed total compensation of $16m; last year the current CEO was paid $27.6m.
Rivals
The third reason is competition. When companies make 80% gross margins and a 40% return on equity, competition doesn’t take long to arrive.
Lipitor faced competition from generics and Astra Zeneca’s more potent Crestor, while Viagra was confronted by products from Lilly and Bayer.
Pharmaceutical companies are unique in that analysts know when their product becomes obsolete due to patent expiry. The truth is most companies’ products become obsolete at some point – it’s just less clear when.
SpaceX dysfunction
So as investors contemplate investing in SpaceX at 100x sales (note – not 100x earnings) with a prospectus full of intergalactic images, a huge TAM and lots of fanfare, perhaps the Pfizer example explains why value investors like us will look elsewhere for investment opportunities.
We look for growth, quality and decent management when selecting companies, but won’t overpay for these variables, no matter how good the story.
Sean Peche is a value investor with a Citywire AA rating who manages the Ranmore Global Equity fund (Irish Ucits)
The information and views expressed in this article are for general educational and information purposes only. They do not constitute investment advice.