Chuck Carnevale submits:<< Click to read Part 1In Part 1 of this two-part series we talked about how emotions can cause the stock market to misprice companies over short periods of time. The important point we endeavored to make is that being able to recognize overvaluation or undervaluation when it exists is a great benefit to investors.Regarding the healthcare companies we are writing about in this article, it's important to recognize that during the “great recession” of 2008, each of these companies maintained healthy profit pictures in contrast to most companies who saw their earnings collapsing. Yet, even though their businesses remained strong, their prices fell along with the rest of the market, therefore, undervaluation became manifest for these strong and healthy businesses.Strong Earnings, Weak Prices, Equal OpportunityIn our experience, and opinion, when operating results remain strong but stock prices fall, is when a real opportunity becomes available. Because, when this occurs, we would argue that risk is actually reduced thanks to low valuation while long-term return potential is simultaneously enhanced.This higher potential return becomes available due to leverage. The leverage comes from the stock price first returning to fair value then continuing to grow in line with its operating results over future time. For this particular set of companies as our historical earnings correlated EDMP, Inc. F.A.S.T. Graphs illustrate, finding these companies when they are undervalued is a rare opportunity.Valuation Based on Cash FlowsFor many investors, the concept of valuation is a mystery. However, in truth, fair value is a very straightforward concept. It is based on the principle that a business’ value is determined by the amount of cash flow that it is capable of generating for its stockholders.Therefore, the process to determine value is to simply add up the future cash flows you expect the business to generate and then divide that number by the amount of money you're required to invest. This equation provides the percentage return you are expecting on your invested capital. If that number is satisfactory and commensurate with the risk you're taking to achieve it, then investing makes sense.However, if this number is too low to compensate you for the risk you're taking, then the investment should be avoided. Our EDMP, Inc. F.A.S.T. Graphs do this computation for you, and put it into graphic form.Overvaluation RiskRemember, markets do not always behave rationally. When significant overvaluation exists, so does high risk. On the other hand, when significant undervaluation exists greater opportunity at lower risk logically becomes available.To us, it never makes any sense to debate whether or not an overvalued situation is justified, or for that matter, whether an undervaluation situation is justified. We simply run the numbers and make our decisions based on whether those numbers make sense or not. In the long run, stock prices will move to earnings justified values -- it’s inevitable. This is the beauty of, and the undeniable logic of, mathematics; the numbers either add up or they don't.Undervalued OpportunitiesWe believe that each of the four examples covered in this two-part series represent undervalued opportunities created by the recent market weakness.Whether the current market weakness is justified or not relative to the overall market is not our concern. Whether the current price weakness in each of these high-quality businesses individually is justified or not, is what we are concerned with. It is our contention that the evidence provided by our EDMP, Inc. F.A.S.T. Graphs clearly validate that the current price levels for each of these companies is unjustifiably low based on current fundamentals.Figure 1A below looks at Walgreen Co. (WAG), the nation's second-largest drug retail chain and distributor, through the lens of our EDMP, Inc. F.A.S.T. Graphs since calendar year 1996. The orange line with white triangles represents our modified Ben Graham formula for fair value. Based on the mathematics behind this graph, Walgreen Co.’s stock price was ridiculously overvalued from 1996 through most of 2007. Although earnings were quite good, mathematically they did not justify the lofty valuation.Therefore, in calendar 2007 Walgreen’s stock price fell hard, and then fell harder again in 2008 during the “great recession”. In 2008 Walgreen Co. did become very undervalued before recovering in 2009 back to fair value, then moving slightly above fair value. Recent stock market weakness has once again driven Walgreen's price below its intrinsic value or earnings justified level.(Click charts to enlarge)Figure 1A WAG 15yr EPS Growth Correlated to PriceFigure 1B below goes back in time and looks at Walgreen Co. through the lens of our EDMP, Inc. F.A.S.T. Graphs™ for the period 1996 through calendar year 2000. What should be clear from this graph is that Walgreen’s stock price (black line) was dramatically above its earnings justified level at calendar 2000 year-end as represented by the orange line with white triangles. At year-end 2000 Walgreen’s stock was trading at a PE ratio of 53.8 when its earnings growth rate over this time frame was only 18.2%, therefore, its PEG ratio was almost 3 and therefore, very overvalued.In other words, Walgreen's stock was trading at three times its earnings growth rate. Fair value based on PEG ratio implied a stock price of $14.32 (see flag on Figure 1B), yet the market was inexplicably overpricing Walgreen’s stock at $41.81. Although it cannot be denied that this occurred, it should be obvious that this made no mathematical sense. Therefore, the risk reward ratio for owning Walgreen’s stock was completely upside-down. When looking at Walgreen’s stock value visually with our EDMP, Inc. F.A.S.T. Graphs™ the overvalued situation is plain as day to see.Figure 1B WAG 1996 – 2000 EPS Growth Correlated to PriceFigure 1C below looks at Walgreen Co.’s performance from 2001 to current, which clearly illustrates the danger of overvaluation. Even though Walgreen Co. delivered earnings growth of 11% the lofty starting overvaluation of its stock price ended up destroying investor capital. In other words, the company did great, but shareholder returns were awful thanks solely to overvaluation. From this example it becomes quite clear how important it is to get valuation right.Recently, it seems that the debate regarding the virtues or pitfalls of buy-and-hold is once again waxing on. This example of Walgreen's overvaluation points out that buying and holding only works if the investment is made when valuation makes sense. Overpaying for a company and then holding never makes any sense, because you can't possibly hold it long enough to make any money. This is especially true when overvaluation is as extreme as was the case with Walgreens at calendar 2000 year-end.On the other hand, as we will point out later with our fourth example of a quality healthcare company, Teva Pharmaceutical Industries Ltd. (TEVA), when valuation is sound and then operating results are good, buy-and-hold is a great investment strategy.Figure 1C WAG 2001 – Current Price PerformanceFigure 2A below looks at Teva Pharmaceutical Industries Ltd., a top 15 pharmaceutical company and one of the largest generic drug companies in the world. Headquartered in Israel, Teva trades as an ADR. As Figure 2A depicts, Teva has been able to amass an enviable track record of earnings growth since calendar 1996. Even though earnings flattened a little during the “great recession” of 2008, Teva has been able to generate compound earnings growth of 23.5%.Monthly closing stock price (the black line) has followed earnings in an upward trend since 1996. Teva trades at a mere 13.6 PE ratio and offers an entry dividend yield of 1.3%. In addition to being a consistent earnings generator, Teva has a strong balance sheet and generates significant cash flows.Figure 2A Teva 15yr EPS Growth Correlated to PriceFigure 2B below calculates the performance associated with Figure 2A. As the chart shows, Teva has increased their dividend at double-digit growth rates since calendar year 2001. Capital appreciation of 16.7%, although less than their historical growth rate due to current undervaluation, has nevertheless soundly exceeded the S&P 500.Since Teva started the period 1996 to current with their stock price fairly valued they represent a clear testament to the validity of the buy-and-hold strategy done right. When purchased at a sound valuation, a growing enterprise will reward their shareholders over time, even if the market doesn't currently cooperate. In other words, even though Teva’s stock price is currently undervalued, shareholder returns have been extraordinary thanks to sound valuation at time of purchase and a rapidly increasing earnings income stream.Figure 2B Teva 15yr Price PerformanceConclusionBoth Walgreens and Teva are forecast to grow earnings by double-digit rates over the next five years by leading analysts reporting to FirstCall. Therefore,both of these healthcare blue chips appear to be undervalued at current levels. Also, it would be rational to expect that the dividend income stream for both companies should increase with earnings growth and capital appreciation opportunities are reasonable if not solid.Walgreens has faced some earnings headwinds recently and was forced to deal with a challenging situation with CVS. However, the CVS controversy has been resolved and Walgreens is well-positioned to prosper in the future based on the demographic makeup of our population, notwithstanding healthcare reform. Teva, on the other hand, is in our opinion a compelling long-term opportunity that should benefit greatly from healthcare reform. As a leading developer of generic drugs, reducing healthcare costs is a major attribute of this well financed pharmaceutical.We believe that buying and holding is an excellent investment strategy when valuations are attractive and the prospects for future growth are high. For the better part of the last 15 years, Stryker Corp., Medtronic Inc. (See Part 1) and Walgreens have been overpriced and, therefore, poor choices for investors seeking growth and value. Our fourth selection, Teva, has not been as overpriced as the other three, yet has rarely been as inexpensive as it has for the last few years. Consequently, we suggest that the prudent investor seeking quality at a reasonable price and with a dividend kicker should look into these four blue-chip healthcare companies.Disclosure: Long WAG, TEVA, SYK, MDT at the time of writingThe opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.Complete Story »
