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Are Drug Stocks Cheap Enough for Buffett?

Valuations reminiscent of the Oracle's 'mistake' a decade ago.

by Curt Morrison, MD, FACC | 01-12-05 | 06:00 AM


Warren Buffett likes the pharmaceutical business. During the shareholder question-and-answer session at Berkshire Hathaway's BRK.B 1998 annual meeting, Warren Buffett said he and partner Charlie Munger "just plain missed on pharmaceuticals...we probably should have recognized the fact that some sort of group purchase might have made sense. But we didn't do anything about it." Munger chimed in, "Yeah, we stupidly blew that one." This is according to a transcript published in Outstanding Investor Digest.

Buffett's and Munger's comments alluded to the opportunity presented in 1993 and 1994 when worries about government plans for socialized medicine depressed pharmaceutical share prices. At the 2001 annual meeting, they contrasted that opportunity with the subsequent collapse in technology shares. According to transcripts published by Platinum Capital Limited, Munger pointed out that, "As an industry, the pharmaceuticals have a far better record of high returns on capital, and participation in those returns, than the technology sector ever has." Buffett added, "Not going into pharmaceuticals was a mistake, but we don't feel the same way about technology companies." Buffett reiterated these views in an October 2003 Barron's interview.

Assuming that Buffett hasn't changed his mind since 2003, we can infer that he would be inclined to purchase a basket of pharmaceutical stocks if the industry's valuations fell to levels last seen in the early 1990s. What were those valuations, and how close are we to that buying opportunity today?


Measuring Value

To find out, I looked at the six largest branded U.S. pharmaceutical companies covered by Morningstar. They are Pfizer PFE, Merck MRK, Bristol-Myers Squibb BMY, Wyeth WYE, Eli Lilly & Company LLY, and Schering-Plough SGP. I excluded Johnson & Johnson JNJ and Abbott Laboratories ABT because they derive substantial revenue from products other than drugs. The bar graphs below depict the average dividend yield, price/book ratio, and price/sales ratio for this group of six companies near the end of each of the last 11 years. The yield data and all of the 2004 data are from Yahoo Finance. The rest is from Bloomberg. Note that 2004 data is based on third-quarter reports rather than year-end reports, which won't be available until later in 2005.

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You can see that pharmaceutical stocks were the least expensive by all three valuation metrics in 1993 and 1994, and that they were the most expensive during the period from 1998 to 2000. Recently, the group's price/book ratio has fallen below 1994 levels, and its yield and price/sales ratio are approaching those trough levels. Thus, this basket of pharmaceutical stocks appears to be close to the valuation range that appealed to Buffett a decade ago. What does Morningstar think about recent valuations?

At the Jan. 5 market close, the median Morningstar price/fair-value ratio for the group was about 0.89. This means we thought the stocks were selling for about 11% less than what they were worth. In contrast, the median price/fair-value ratio for all of our stocks under coverage was 1.1 as of the same date. Obviously, we think these drug stocks offer better value than the broad market.

However, we're a fairly conservative bunch, and our recommended buy price for the group won't be reached unless these stocks drop to about 70% of our fair value estimate. At that level, the drug group would be cheaper than it was in 1994 as measured by dividends, sales, and book value. This is illustrated in the table below.

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Of course, we don't value stocks based on book value, sales, or dividends; we use a discounted cash-flow model. Unfortunately, Morningstar wasn't estimating fair values for stocks in 1994, so I can't tell you if drug companies were selling for more than 70% of fair value at that time. It's not a stretch, however, to surmise that we would have considered this group significantly undervalued.


Accounting for Risks

Since 1994, plans for socialized medicine have been abandoned, but the pharmaceutical industry still faces the possibility of growing government influence over drug prices. These companies also face significant litigation risks, the impending loss of patent protection on major products, and a dearth of new blockbuster drugs on the horizon. In my opinion, all of these negatives and more are factored into our models.

We've allowed for large product liability settlements against Pfizer, Merck, and Wyeth, and we've projected a rapid loss of sales for any drug losing patent protection. Although the pharmaceutical industry has a history marked by bursts of innovation, we don't assume that these companies will reap a windfall from a new wave of discoveries.

The pharmaceutical industry has earned very high and stable returns on capital over a long period of time, but that doesn't guarantee the returns will always be so high. I think a gradual, moderate erosion is probable, mainly because I think the Medicare Modernization Act of 2003 will eventually lead to lower drug prices. That law makes the government a giant pharmaceutical buyer with potentially enormous influence over product pricing. Although the law prohibits the government from negotiating lower prices, I derive little comfort from that as a shareholder in Merck and Novartis NVS. The door has been opened, and I think it's prudent to assume that the government will ultimately step through it.

However, similar concerns in 1993 proved to be unwarranted, or at least premature by more than a decade, and our models assume that returns on capital will fall to the weighted average costs of capital over the next 20 years. In other words, we assume that the drug business, which has been great for many decades, will decline to mediocrity. This is a conservative projection, I think, and it can be considered a margin of safety that is already built into our fair value estimates.

If pharmaceutical company stock prices fall to 70% of our estimated fair values, our "consider buy" range, then investors should do very well with new positions. We can't speculate about whether Warren Buffett will be buying pharmaceutical stocks in the future, but we would back up the truck if they dropped into 5-star territory.