Reader Mailbag: Playing the Covid-19 Vaccine

Reader Question:

Do you think it is too late to invest in the players involved in developing vaccines for Covid-19? If not, is it better to go with the large companies or the smaller upstarts?

I think there are two angles here. First, Covid itself. I doubt anyone really knows whether these vaccines will be effective enough to get rid of Covid (for the most part) within a year or two, or if we are dealing with a new virus that is constantly mutating and here to stay, in which case annual Covid shots are probably in our future. Since the experts would probably punt on this question, I will too. It sure seems too early to rule out annual shots that would likely be solid moneymakers for the companies involved, but I am not sold on the idea that we should place an investment bet on one of those trajectories, as there is still plenty we don’t know.

The more interesting topic in my eyes is the notion that this pandemic has accelerated the development of mRNA therapeutics, we have evidence that the mechanism works (at least in the short term, longer term data is not available yet), and thus it is fair to ask whether this has been a proof of concept phase that will also accelerate the development of similar compounds for indications other than Covid.

In my view, this seems very plausible, and maybe even extremely likely. If this is not just a one-time boon for companies like Pfizer, Johnson and Johnson, Moderna, and BioNTech, then it is probably not too late to invest based on that particular thesis.

So in that case, do you go with the big players or the smaller ones? I think the smaller firms have a leg up from a long term investment standpoint. The industry giants like Pfizer and J&J are so big that the impact of new technologies has a limit in terms of how much they can swing the earnings of these conglomerates. Add in the fact that they have existing products on a rolling schedule of patent expirations, and there are more offsets to the growing parts of their business. The same thing simply isn’t true for the likes of Moderna and BioNTech, and it is also entirely possible the former group eventually offers big money to acquire the latter group.

Taking this thought experiment one step further, I think it is interesting to compare Moderna and BioNTech since they are both publicly traded and have Covid vaccines on the market. While Moderna’s equity market value is currently 2.5 times larger than BioNTech, the latter company has more employees and is expected to generate roughly 75% as much revenue ($7.84 billion) in 2021 (according to the current consensus forecasts on Wall Street) as Moderna ($10.5 billion).

Now, these revenue forecasts are probably only guesses at this point, and having more people doesn’t mean you will have more success in the lab, but given the valuation gap, it seems like there might be more investment value on a relative risk/reward basis with BioNTech.

I have been thinking about that comparison for a while, although I have not yet invested in any of these companies. However, it remains top of mind, especially as the market’s strength affords us fewer and fewer bargains by the day.

Full Disclosure: No positions in the companies mentioned at the time of writing, but that may change at any time

As Markets Stabilize While Peak Infection Rates Loom, Where Should Fresh Capital Go?

My last post highlighted the fact that the U.S. stock market in recent times has tended to find a lot of support around 15x trailing earnings. It appears that equities have calmed down a little in recent days, with a bottom having been made (perhaps temporarily) on March 23rd. On an intra-day basis (2,192) the valuation at the bottom was 14.0x 2019 S&P 500 profits. On a daily closing basis (2,237) it comes to 14.2x and on a weekly closing basis (2,305) the figure is 14.7x.

I am not going to predict that we have seen the lows. Even the experts in the field are merely guessing as to Covid-19’s ultimate infection path and even scarier to me is that I doubt health and government officials even have a plan for a slow loosening of social distancing guidelines, so we really don’t know what to expect from a economic rebound perspective. On one hand, I am comforted that the market did find a bottom around similar levels to recent years’ corrections, but on the other hand this situation is so much different than prior instances that I am not sure it is a very strong comparable event.

So rather than try and guess these things, like so many pundits in the media insist on, I think it is more helpful to think about where fresh capital could be deployed on a long-term basis as we wait this whole thing out. I am finding it too early to average down on more controversial existing holdings (travel-related, for example) because companies have not given us much data yet. Most have disclosed cash balance and credit line availability, but without knowing cash burns rates that only tells us so much.

So then the attention turns to businesses that are publicly traded, beaten down, and are less reliant on credit availability even if they are shut down. Essentially, high quality businesses that are on sale now but typically are not. Sure, there are examples in sectors where headwinds abound (Starbucks down 35%, for example), but there are more obscure ideas too. How about the few publicly traded professional sports teams? How confident are we that sports franchise values will continue to rise over the next 5 years? Even if seasons are cancelled, will the franchises lose 25-35% of their value for a significant amount of time? How often can small investors buy into sports teams at a big discount? Not often.

I know rental income in the near-term is problematic, but seeing owners of hard assets like real estate down 50-70% in a month is startling (and likely an opportunity). And you don’t need to go out and buy mall owners if you don’t feel inclined. How about Ventas, one of the leading owners of medical facilities? The stock is down 65% since February.

How about the big banks that were forced to be well capitalized so they could weather something like this? Jamie Dimon just went back to work after emergency heart surgery and JP Morgan Chase is widely considered the best-run bank in the world. It’s stock is down 40% from its 52-week high.

There are many companies I feel like I need for information from before I can decide whether to cut them loose or buy more shares. There are others where I feel like I can get comfortable given the low price, no matter how the next few months shake out. If you find unique situations where the franchise value is likely very secure and yet the stock is still down far more than the market itself, take notice. You might be surprised what you find. I mean, honestly, should Target stock be down 30% in this environment?

Happy hunting!

Full Disclosure: Long shares of Starbucks at the time of writing, but positions may change at any time

Plenty of Travel-Related Stocks Ripe for Bargain Hunting with Multi-Year Outlook

I find it interesting that the financial community is making much about the various drug companies working on coronavirus vaccines. History suggests that 90-180 days from now the outbreak will be off the radar and the global economy will be bouncing back. I am not sure a SARS vaccine, for instance, has much financial value these days. These strands of virus tend to have one-off impacts.

Much like during the SARS outbreak, or after the 9/11 attacks, travel stocks are taking it on the chin right now. As a long-term contrarian investor, I cannot help but allocate some existing cash balances into these stocks. 2020 will be a throwaway year from a financial perspective and the markets should relatively quickly refocus on 2021 and a more normalized operating environment.

Does it matter which companies one targets? In many cases, probably not. Having already held Expedia (EXPE), and being only more excited after hearing Barry Diller’s plan to reinvigorate the company’s business, I can’t help but be elated that the post-earnings rally we saw earlier in the month has now been given back completely. I am modeling $10 of free cash flow per share in 2021 (assuming a normalized economy) and the stock is fetching $105. Plug in your expected multiple of FCF and calculate the upside accordingly.

Booking Holdings (BKNG) has more international exposure and reports after the bell today. At $1,675 and about $100 of per-share free cash flow, that one is worth watching as well.

I have also been looking at the cruiseline sector and already had global market leader Carnival (CCL) on my watchlist pre-virus due to a depressed stock price (due to a large capex cycle depressing free cash flow generation). I have begun accumulating shares, as the single digit P/E ratio and dividend yield north of 5% (payout ratio of less than 50% on normalized earnings) appear favorable to historical levels.

To be clear, I am not predicting how bad coronavirus will be, or when travel-related stocks will bottom. Instead, I am taking my normal 2-3 year (minimum) holding period assumption and making a bet that buying high quality travel companies during times of near-term distress will pay off over the long-term. History suggests it will.

Are Money-Losing Companies Ever Worthy of Value-Oriented Investors' Time?

As a valuation-based contrarian investor, it is relatively easy for me to make a strong case against allocating investment dollars to money-losing tech IPOs that pay out stock compensation equal to 20% or 30% of revenue to boost their "adjusted EBITDA" and GAAP free cash flow metrics and trade for 15 or 20 times that revenue. Simply put, the growth required for a company to "grow into" a 20 times revenue multiple, or a 100 P/E multiple, is so enormous that 90%+ of all businesses will never get there.

Of course, there are some that will and investing in those stocks can be very rewarding. Josh Brown, CEO of Ritholtz Wealth Management and frequent CNBC commentator, is quick to point out to television viewers that he is generally opposed to avoiding unique growth stocks solely due to valuation concerns. He walks the walk too, considering his purchase of shares in Shake Shack (SHAK), a regular ol' restaurant chain currently trading at more than 6 times 2019 revenue and more than 50 times 2019 EBITDA.

Shares of Shake Shack surged out of the gate after an IPO in 2015 at $21 but insane valuation levels could not sustain the 4-fold rise for very long. After a period of consolidation, the valuation is once again getting frothy as the stock regains its former highs.

Just because I don't think SHAK is worth its current valuation, even if it does reach its goal of over 400 domestic locations (vs ~150 today) and tons of franchised units overseas, I could be wrong. If the company becomes the second coming of McDonalds (MCD) 20 years from now, Josh will be right and we will all look back and say the $3.6 billion equity valuation in 2019 was a great entry point! So... if you feel that strongly about a company, and there is enough market opportunity for them to ultimately grow 5x or 10x bigger, a high growth investment can pay off regardless of the initial price paid.

Since I have been poking fun at folks paying 20 times sales for cash-burning, cloud-based software companies, I wanted to be transparent with my readers about the client portfolios I manage. Believe it or not, there is one high growth, money-losing stock that I have parked in some client portfolios; Teladoc (TDOC).

TDOC is the global leader in the relatively nascent telemedicine provider space. Just as technological innovation is disrupting many traditional sectors of the economy, TDOC is trying to make it commonplace for patients to access medical care via teleconferencing technology. Imagine how many visits to doctor offices do not actually require in-person consultation. Accessing medical providers remotely is not only more convenient for the patient, but it can reduce costs across the system.

Clearly the telemedicine trend has yet to take off globally, as it is very early on in being rolled out. It is gaining a lot of traction in certain subspecialities, such as behavioral and mental health, and I believe it could be very common a decade from now. TDOC has established itself as the leader, and with equity currency from the firm's 2015 IPO, they have the ability to use M&A to further their position worldwide.

All of that said, you may have guessed that TDOC is losing money. Like many tech firms I scoff at, they are content to operate at a loss to build their leadership position and hopefully dominate the market over the very long term. In terms of growth, so far they are succeeding. TDOC's annual revenue has gone from $20 million in 2013 to what should be well north of $500 million in 2019. Such growth explains the generous valuation implied by the current $58 per share stock price; an equity value over $4 billion and price-to-sales ratio of 6x on 2020 estimates ($675 million). My internal estimates show EBITDA in 2019 to the tune of negative $40 million.

To conclude, I think Josh Brown is right - sometimes valuation does not matter for growth stocks. That said, when dozens of businesses are trading at crazy prices relative to underlying sales and earnings, we should assume that most of those won't work out for long-term investors if they overpay. I would have to be pretty confident that the upside potential is worth the risk. And in the case of TDOC, I can envision a scenario where telehealth is huge and TDOC dominates the field, but time will tell if they are the right horse to bet on.

Johnson & Johnson Stock Not Discounted Much After Renewed Talc Media Blitz

Shares of healthcare giant Johnson and Johnson (JNJ) have come under pressure in recent days as media reports have once again resurface, suggesting that the company has potentially hid evidence that trace amounts of asbestos have been found in the talc powder products over multiple decades.

Whenever news like this hits, especially with large dominant franchises with plenty of free cash flow to cover possible legal verdicts (think BP earlier this decade), it pays to see if investors are getting a short-term bargain, enough to compensate them for what is likely to be plenty of headline risk over the coming weeks and months.

With JNJ shares only down about 15% from their highs (not much more than the S&P 500 index), no such bargain seems to have presented itself yet. I estimate JNJ is likely to report free cash flow of around $6.75 for 2018, which gives the stock a current multiple of 19.3x on a trailing basis.

While such a price is not sky high by any means, it is probably about right for a company of JNJ's size. Looking back over the last five years, we can see that JNJ has closed out each of those year's with a trailing free cash flow multiple of between 18.3x and 21.6x. Therefore, the market seems to agree with my conclusion about a fair valuation.

For me to get interested in playing JNJ as a short-term contrarian, long-term investment play, I would probably have to pay around 15x free cash flow, or near $100 per share. We are far from there at this point, and unless some impressive jury awards play out in plaintiffs' favor, or the media finds evidence that is a bit more damning, we probably won't see the stock get that low.

With Aetna Buyout Set to Close Soon, CVS Health's Flat-lined Stock Still Looks Cheap

Last October I wrote about the just-leaked CVS Health (CVS) bid for health insurance giant Aetna (AET) and tried to convey the notion that the move was about far more than just diversifying away from retail pharmacies for fear Amazon might compress margins in that industry. Interestingly, CVS's stock price was $69.05 when I published that note, and today it closed at $69.05. So almost 10 months later and all investors have earned from the shares is the not-too-shabby 3% annual dividend.

CVS reported a solid second quarter this week and is on pace to book nearly $7 of free cash flow per share in 2018 ($6.88 in my internal model), which puts the stock at 10 times free cash flow, a price normally reserved for melting ice cube businesses. And there are plenty of people who see CVS (incorrectly) as just a bricks and mortar pharmacy company destined to be disrupted by some trillion dollar market value tech darling. Others acknowledge their huge pharmacy benefits management business (Caremark), but believe the thesis that those firms are actually robbing their commercial clients blind and helping boost drug prices, when the opposite is actually true (and hence why their clients don't fire them). If both of those notions turn out to be correct, CVS will not be a good investment over the next 5 or 10 years, but I am taking the opposite view.

In fact, the story will get even better when the Aetna deal closes (CVS management indicated on their quarterly conference call this week that September or October is the most likely timeframe for closure). Essentially, CVS is building a healthcare services juggernaut, it seems to me anyway, and will be able to use a vertically integrated business model to offer consumers numerous options and generate efficiencies in an otherwise complex healthcare system. Bears on the company seem to fail to realize that a network of drugstores and in-store clinics, coupled with pharmacy plan management, assisting living and nursing home drug distribution, and insurance plans is an all-encompassing system that can be designed and integrated in such a way as to drive convenient usage from customers of all shapes and sizes, which in turn should bring down costs as scale is leveraged.

Now, there is no guarantee that the company will figure out the best way to harness this potential, but the goods news is that the stock is pricing in failure already at 10x free cash flow. Nothing positive is being considered by most investors and many of them figure the 3% dividend will be immaterial once Amazon announces 2-hour prescription fills delivered by drone starting in 2022 (that is merely speculation on my part -- no announcements have been made). However, when you look at the breadth of CVS's offerings it seems to me that this company is more than just a bricks and mortar retailer selling a commodity at a higher margin than Jeff Bezos would. It does not seem like something the tech giants could duplicate successfully.

As for the PBM side of the business, a lot has been made about pharmaceutical rebates and how they may be encouraging drug prices to remain high on a gross basis. The anti-Caremark thinking assumes that drug markers are giving the PBM rebates on drugs and those payments are juicing the profits of the PBM while patients pay huge out of pocket costs. CVS told investors this week, however, that they keep just $300 million of rebates annually, and pass the rest (roughly 97-98% of the total collected) back to their clients in one form or another (different clients choose different structures). That $300 million figure represents just 4% of the company's annual free cash flow.

Put another way, in a world where PBM plans are restructured so that no rebates are kept by the plan manager, CVS's free cash flow would drop from $6.88 to $6.59 per share. Not only is that hardly enough reason for the stock to be trading where it has been for the last year, but it is unlikely that Caremark would have to give up that $300 million at all. Rather, the PBM contracts would likely be changed to move away from rebates at all, and be underwritten in other ways such that certain folks would no longer insist rebates were the problem. Given that PBM clients are renewing their contracts in the high 90 percents every year, providers like Caremark would likely have no trouble keeping their existing business relationships, at the same underlying profit margins, even if they changed how the reimbursement of negotiated drug savings were handled.

As an investor in CVS Health, I am intrigued to see what the company can do with Aetna added to the mix. Since I don't expect their business to begin a slow decay over the next few years, I am sticking with the shares, despite them merely treading water lately, as I firmly believe the business is far more resilient and value-providing than the bears are giving it credit for. Even at 15x annual free cash flow, still a material discount to the S&P 500 index (remember when consumer staples used to trade at a premium?), CVS stock would trade north of $100 per share. Call me crazy, but I think we will get there sometime within the next 2-3 years. Add in a 3% dividend while we wait and the upside potential is impressive, especially given how negative sentiment is today (which limits further downside to some extent). 

Deal Dead? Express Scripts Has 28% Upside to Cigna Buyout Offer Price

With AT&T (T) and Time Warner (TWX) currently fighting in court to prevail over the federal government in its anti-trust lawsuit, all eyes in the merger arbitrage world are focused on whether so-called "vertical" mergers will be endangered in the Trump Administration. Typically, lawsuits to block M&A transactions have centered on competitors trying to get together to reduce competition and increase pricing power post-combination, but the current fight puts vertical integration in the crosshairs, as the infrastructure company is trying to add content to diversify its business. Given how low sentiment is on Wall Street for paid television content production, investors clearly don't believe a simple merger would give the content producers monopolistic power, but we will have to see what judges think.

One of the more interesting cases is Express Scripts (ESRX), the large pharmacy benefits management company that was recently (March 8th) offered a 31% premium to be acquired by health insurer Cigna (CI). Many believed that ESRX was in play after becoming the lone major PBM to not have a dance partner. And after CVS Health (CVS) -- which owns another large PBM in Caremark -- made a bid for Aetna (AET), it was clear that insurance and pharmacy benefits management were consolidating to the point where ESRX as a standalone business was becoming obsolete.

Express Scripts stock was trading at $73 when the $96 deal price was announced, and the stock jumped initially... for a few hours. It now fetches around $70, as investors bet that vertical mergers, even if allowed in the media business, have a steeper hill to climb, in part because multiple deals are pending and allowing all of them to go unchallenged, could be seen as risky by the government.

With ESRX having 28% upside if the deal is allowed, it might seem like a no-brainer risk/reward situation to go long the stock. After all, at current prices the shares trade for just 10x 2017 earnings per share, with that multiple falling to just 7.5x if you believe the mid-point of the company's 2018 earnings guidance ($9.37), which is getting a big boost from a new, lower corporate tax rate.

The headwind in this case is that Express Scripts is slated to lose one of its biggest customers (Anthem), in 2020. Interestingly, Anthem sold its PBM unit to ESRX in 2009, which paved the way for the current client relationship. However, Anthem is regretting the contract terms (they claim they are being overcharged, whereas ESRX says they are simply abiding by the terms of their contract) and will shift its business to CVS in 2020, while ironically starting their own PBM business internally (again). If only Anthem had kept the business in-house all along...

It does appear that Anthem is getting the short end of the deal. Express Scripts earned EBITDA of $5.29 per prescription claim in 2017 across its entire business, but with Anthem it is making over $10 per claim. So you can see why Anthem is upset and wants a new partner. ESRX will make good money for the next two years -- through 2019 -- and then will see 1/3 of their EBITDA vanish. And that explains why the stock trades at 7.5x 2018 earnings. Assuming the Cigna deal is blocked, earnings in 2020 are likely to be in the $6.50 per share ballpark, giving the stock an "adjusted P/E" of around 11x, and making Cigna's offer worth about 14x.

While I have not completed all of my due diligence on Express Scripts, it appears to be worth a look. Absent a buyout from Cigna, the company faces mounting criticism as a middleman in the pharmaceutical sector that supposedly drives up costs for consumers, despite existing for the purposes of negotiating discounts for its corporate clients. The way I see it, if ESRX was not earning its cut, its customers would fire them. Anthem aside, ESRX will see a client retention rate in 2018 of between 96 and 98 percent, according to the company. Without ESRX, employers would have to move their pharmacy plan management in-house, which would probably mean worse results (due to lack of experience), and higher costs (the point of outsourcing in the first place is to save money and resources). If corporations could do what PBMs do, internally and for the same or less money, why would companies like Express Scripts exist at all? 

Is The CVS Health/Aetna Proposal Really Just About Amazon?

Financial journalists seem to have a pretty simple playbook these days. Most any retail-related corporate development is a direct result of Amazon (AMZN). Plain and simple. No questions asked.

Last night it was reported that CVS Health (CVS) has made a bid for health insurer Aetna (AET). Immediately the media closed the book on the strategic rationale for the deal; Amazon might soon start offering mail-order prescriptions and CVS needed to make a bold move to counter that attack.

If CVS is really most worried about Amazon stealing away its pharmacy customers, would the best counterattack to be buy the country's third largest health insurance company? Does that make sense?

It seems to me that the best competitive move to help insulate you from losing prescription share to Amazon would be to buy a last mile delivery company and use it to offer same-day or next-day prescription delivery to the home. After all, it is not like Amazon has any scale in the drug wholesale business, considering that they have yet to even enter the business to start with! And even if they do get into the business, are they really going to be able to get better pricing for drugs than CVS can, with its existing network of 10,000 retail pharmacies?

I would suggest that the CVS bid for Aetna is more about extending their corporate strategy of becoming a vertically integrated healthcare services provider. You have to remember that CVS bought Caremark, a pharmacy benefits manager, or PBM, more than a decade ago. They started Minute Clinic, the largest retail walk-in clinic chain in 2000. They acquired Omnicare, a pharmacy specializing in nursing home services, in 2015. Becoming more than just a retail pharmacy chain has long been the entire idea behind the company. It also explains why reports say that CVS and Aetna have been talking for six months (this idea was not just thrown together quickly because Amazon is applying for pharmacy licenses).

Adding a health insurer to the mix was a logical extension of that. Competitor United Health took the opposite route, as an insurance company that added Optum Health, a PBM, later on. That strategy has been wonderfully successful and I suspect that CVS and United will dominate the integrated healthcare services business for years to come.

Of course, the narrative on Wall Street has nothing to do with any of this. CVS stock is getting crushed today and United Health is up three bucks. The one-year charts make it seem like these businesses have nothing to do with each other:

To me it is simply baffling that UNH trades for 21x 2017 earnings estimates and CVS commands just 12x. If CVS really does build out a UNH-like operation, with a small retail pharmacy division, I can't fathom how that valuation gap won't narrow over time. But the investor community right now just can't get that bricks and mortar component (no matter how small it would be post-Aetna) out of their heads.

What is probably most interesting is that Amazon does not have a history of putting companies out of business when it enters new markets. Amazon started selling books online in 1994. It launched the Kindle e-reader in 2007. If any bricks and mortar retailer should have been gone by now, it would have to be Barnes and Noble. And yet they are still alive and kicking:

A lot of people thought that Best Buy was finished once Amazon started selling a huge selection of consumer electronics. After all, with thousands of reviews, great prices, and fast shipping, why bother going to a store to buy a TV or computer? And yet, here is a five-year chart of Best Buy stock:

All Best Buy had to do was offer price-matching and quick delivery to keep a lot of market share from people who like buying online. And then you will always have a subset of folks who like kicking the tires in-person and asking knowledgeable people questions about the products.

While Amazon's reach and e-commerce infrastructure will seemingly allow it to always take a certain amount of market share, it does not typically spell death for competitors. This is especially true when Amazon can't offer anything better than anyone else. Plenty of companies can offer good selection and good prices, and they are finally spending the money to handle the quick delivery too. And with physical stores, in some cases they even have a leg up on Amazon.

Jeff Bezos likes to say "your gross margin is our opportunity." By that he just means that if you mark up your prices too much, for no good reason, Amazon will undercut you and take your market share. For that to work, margins have to be high in the first place. For books and consumer electronics, gross margins aren't very high. For other areas like auto parts, where product markups are 100%, do-it-yourselfers will probably shift business away from bricks and mortar retailers and to Amazon for certain items.

In the case of pharmacies, we are not talking about huge markups, from which Amazon can really offer a significantly better deal. Sure drug prices are sky-high in many cases, but there are a lot of middlemen that split the profits. Manufacturers ship product to distributors, who stock the shelves at the pharmacies upon receiving orders, who resell to consumers. Amazon is starting from scratch and has none of those capabilities yet. If their plan is simply to buy drugs from wholesalers and ship them via Prime to their customers, there is not going to be a lot of margin to shave off in the process, nor will they be doing anything different than others.

That becomes even more true because they will not have scale at the outset to get better wholesale pricing from the suppliers. And if Amazon goes directly to the drug makers demands better prices, the drug companies will just say, "sorry, get your supply from the same places everybody else does." They are not going to voluntarily give up margin when they don't have to.

And then there is the whole issue of whether Amazon can partner up with the employers, PBMs, and insurers to get access to their customer bases. Is Wal-Mart or Target going to add Amazon to their preferred network for employer-sponsored prescriptions? If CVS buys Aetna, will they let Aetna members get their drugs through Amazon at the same prices they could through CVS retail or mail order? And what is stopping CVS from hiring drivers at $15 an hour to drive around their local neighborhood delivering prescriptions to people's homes? Does Amazon really have any competitive advantages in this space, assuming they enter it in the future?

I guess they could buy Rite Aid and Express Scripts, to add pharmacies and a PBM, but even after they spend all that money and integrate those businesses, aren't they just in the same boat as CVS and Walgreens? Sure they are players at that point, but how will they crush the competition?

This is why I am skeptical that Amazon will try to do everything, will succeed at everything, and will kill off legacy providers that have been doing this stuff for decades. When I see a powerhouse like CVS, which will only get stronger if it buys Aetna, trading at 12x earnings, with the rest of the market trading at 20x it just doesn't make a whole lot of sense. As Warren Buffett would say, "in the short term the market is a voting machine, but in the long term it is a weighing machine."

Full Disclosure: Long shares of Amazon and CVS Health at the time of writing, but positions may change at any time

Gilead Sciences Take First Step Towards Higher Valuation Multiple

It has been a tough couple of years for shareholders of Gilead Sciences (GILD), the leader in treating HIV and Hepatitis C, or HCV. After shocking the biotechnology world by buying little known Pharmasset in 2011 for $11 billion, which gave them what would be become the leading HCV treatment, Gilead's stock soared as Sovaldi (and later iterations of the drug) set a record for the best drug launch in the history of the industry.

However, as Gilead effectively cured thousands of patients in short order, it became clear that their HCV franchise would peak, and then slowly decline over time. As profits peaked and turned down, so did GILD shares, beginning in 2015:

What happened next was a classic Wall Street (read: short term focused) reaction. The stock went from darling to dud because Gilead had nothing in their drug pipeline that could offset the loss of HCV revenue after those initial patients were cured. At the beginning of 2017, GILD stock fetched $72, or just 6 times trailing 12-month free cash flow. A free cash flow multiple of 15-20 is pretty normal for the pharma and biotech space, so investors were essentially saying that GILD was going to see its profits decline more than 50% permanently.

I started buying the stock in late 2016 because the situation seemed very similar to instances when quality drug companies come to the end of the patent life for one of their best selling medicines. Knowing that generic versions are coming, investors drastically cut the earnings multiple they are willing to pay, in case new drugs never come to pass.

Of course, this ignores the fact that the vast majority of the time those same companies take actions to limit the profit decline and eventually grow again. In my October 2016 quarterly letter to clients I wrote the following:

"The negative case for Gilead ignores the fact that corporations are very much like living creatures; they do not exist in a vacuum but rather can pull other levers and take actions to offset negative events. For instance, what happens if Gilead discovers new medications for other diseases? What if they siphon profits from their HCV drugs to acquire other companies in order to diversify their product pipeline? What if they use profits to repurchase their own stock, making each remaining share more valuable? Better yet, what if they do all three?

For example, Pfizer’s cholesterol drug Lipitor had sales of $9.6 billion in 2011. In 2012 sales fell by 60% after the patent expired and generic versions hit the market. To reflect this known reality, Pfizer stock closed out 2011 trading for $21 per share, or roughly 9x annual earnings. By 2015, Lipitor sales had plunged by nearly 90% but Pfizer’s annual earnings had only fallen by 5% as other products filled the void. Pfizer stock ended 2015 trading at $32, or 14x annual earnings."

Today we learned that Gilead has agreed to acquire Kite Pharma (KITE) for $12 billion in what will likely be just their first step in a process to build a formidable oncology franchise. I would expect more deals like this, perhaps 1 or 2 over the next 12-24 months, to further diversify the company away from HIV and HCV.

If the transition is successful, investors will likely reward Gilead with a more normal valuation. The stock is only rising by 1% today, but over time there is no reason the valuation gap (compared with peers) will not close more dramatically. It will be a long time before Gilead gets back to peak profitability (2015 produced $13 per share of free cash flow), if they ever do, but let's assume they can earn $10 per share in five years (versus perhaps $8 this year). Assign a reasonable 15 multiple to those earnings and Gilead shares would double from their current price.

Full Disclosure: Long shares of Gilead at the time of writing, but positions may change at any time.

Healthcare Stocks Look Poised To Rebound In 2017

Perhaps one of the more surprising stock market trends post-election has been the relative inability for the healthcare sector to get back on track after taking a beating during the campaign season. With government deregulation on the way, as well as a bipartisan bill having passed Congress late in 2016 that will serve to loosen the FDA drug approval process, rational minds might have expected healthcare stocks to stage a large rally, much has been the case with banking stocks (same thesis; rolling back the regulations put in place post-recession).

We have seen a bit of a pickup in recent days, but after an initial one-day surge on November 9th, healthcare stocks have been lagging generally. I fully expect that 2017 will be a much better year for the sector. Abusive drug price increases will surely still get the attention on lawmakers, but that practice should come to somewhat of a halt now that the industry has seen what can happen to the likes of Valeant (VRX).

While investors will have to temper their growth rate expectations for pharmaceutical-related companies, the fundamental demand story should remain intact longer term. The strong companies should have no trouble churning out consistent sales and strong cash flow. Doing so will prove to investors just how resilient the industry can be, and should result in more normal valuations for most players in the sector.

To give you an example of how strange some of the price action has been in these names, consider one that I have been accumulating recently, both personally and for clients: CVS Health (CVS). This leading healthcare name has seen its share price take a stunning downward turn, from over $100 to as low as $70 per share. It's hovering around $80 currently.

CVS is not some small drug company with a few products that has grown by dramatically increasing prices. We are talking about a blue-chip franchise with leading positions in both retail drugstores and pharmacy benefit management. The historical record of shareholder value creation is impressive. From a long-term demographic perspective, CVS stands to benefit greatly from drug innovations and an aging population.

And yet somehow the stock is currently fetching just 14 times annual earnings, a whopping 30% discount to the S&P 500 index. With overall valuations in the market in the upper band of the historically normal range, CVS looks like quite a bargain, even as the sector has been a focal point for criticism. While stocks like this have hurt investor performance lately, myself included, I see little reason to think 2017 cannot be the start of a healing process for an excellent American company like CVS Health.