Today Investors are keenly focused on income while simultaneously very risk averse. This current behavior brings with it a level of frustration. The appetite for yield is high precisely at a time when yields on the traditionally safest investments like bonds and CDs, etc. are at historic lows. On the other hand, dividend yields on many blue-chip stocks are close to double what investors would normally find with this asset class.
In many cases, these abnormally high yields are purely a function of historically low valuations. Ironically, the only logical reason that we can identify as to why valuations of blue-chip stocks are so low is fear (risk aversion).
The Many Faces of Risk
In truth, the concept of risk is a multifaceted subject. Yet investors and writers often throw the word around as if it had a single or universal meaning. In reality, there are many faces to risk and prudent investors need to consider and evaluate them all before making investment decisions. Of course the most obvious risk, and perhaps the one that investors fear most, is loss of principal, total or even partial.
The great recession of 2009 heightened investors' focus on this area of risk. This anxiety regarding loss has persisted even after two years of healthy gains and recovery for equities in general. Therefore, we offer the following admonition; it would be imprudent to ignore the other faces of risk by excessively focusing only on fear of loss.
The concept of risk is too vast to be covered in one article. Therefore, we will limit our discussion by covering only one additional aspect of risk that we feel is of great importance. Purchasing power risk is one area of concern that we feel has not recently been given the attention it deserves. Money flooding into low yielding treasury bonds provides evidence for this statement.
Investors are so concerned with protecting the nominal value of their principal, that they expose themselves to the ravages of their purchasing power by inflation. More simply stated, it's not enough to merely maintain purchasing power today, it's also imperative to prudently grow purchasing power over time as well. This means increasing both the income and principal components of your portfolios.
Fortunately, the awareness behind the need for both growth of principal and income appears to be building. More and more the investment community is offering articles and discussions about dividend paying common stocks. However, with valuations of many blue-chip dividend paying stalwarts still at historically low valuations, the level of awareness is nascent.
Even though we are encouraged by this growing awareness, we caution that balance must also be maintained. The tug-of-war between investing for growth versus investing for income needs to be properly executed. Otherwise, the investor's portfolio is at risk of falling into the mud (there's that word risk again).
The pharmaceutical industry appears to offer a fertile field of opportunity for investors seeking growth of principal and growth of income. Valuations look low and therefore, yields are higher than normally expected for this once high-growth sector. But investors need to keep in mind that investing is a dynamic process where the fortunes of individual companies, and even of complete industries, can rapidly change.
Sometimes this occurs as a result of disruptive technologies. Examples would include: Henry Ford and the buggy whip, the Internet and the newspaper industry, and numerous others. Additionally, the fortunes of an industry can face political hurdles (i.e. healthcare reform), and sometimes markets can simply become saturated (i.e. autos and electronics). These are only a few of the reasons why the prospects of an industry or sector can rapidly change. In many ways, the healthcare sector may be facing them all today.
In this article we are going to look at big Pharma through the lens of our F.A.S.T. Graphs™ research tool. One of the real advantages that our tool offers is the ability to easily review different time frames. We can use it to look at any historical period, for example, 1992 to 2001. One of our favorite exercises when initiating research on a company is to start with a 20 year (our maximum available) historical price and earnings correlated F.A.S.T. Graphs™ followed by a 15 year, then a 10 year, then a five-year, etc.
With this exercise we can determine whether growth is accelerating, decelerating or staying the same. We feel this is valuable information to have. For illustration purposes we will offer various F.A.S.T. Graphs™ over different time frames on our first example Merck & Co. (MRK). Due to space constraints for the remaining companies, we will only provide two historical price and earnings correlated F.A.S.T. Graphs™ with accompanying performance.
Several beneficial side effects of this analysis will be to provide illumination on the importance of the following three critical investment concepts: 1. Earnings and earnings growth 2. Dividends and dividend growth 3. True Worth™ valuation-over or under. Our objective is to utilize the F.A.S.T. Graphs™ research tool to illustrate the effect that each of these metrics have on long-term shareholder returns.
The graphs will show that the rate of change of earnings growth will be the primary determinant of investor returns and the level of dividend income. However, the graphs will further demonstrate how overvaluation will reduce returns and how undervaluation will enhance returns. Consequently, we urge investors to carefully consider each of these three important metrics.
Merck & Co. (MRK) in the Rearview Mirror
Our first historical price and earnings correlated F.A.S.T. Graphs™ and accompanying performance results will look at Merck & Co.