Three Once-in-a-Decade Stock Values

1. The companies' historic economic advantages are stable and durable.
2. Stocks are fairly priced over long-run horizons.
3. Ten to 20 years is a long-run horizon.

If these assumptions are true, then the companies' future growth and returns on assets will be similar to past results, and the historic average valuation is the correct valuation. I'll discuss these points in this HCI issue before presenting data highlighting the value of entrenched economic advantages, and then closing with comments about portfolio construction and performance evaluation.

Before we start, I'd like to encourage you to write me at to discuss a point, ask a question, or say hello; I enjoy the correspondence.

Mature, Stable Growth Companies
Medtronic was founded in 1949, Johnson & Johnson in 1885, and Pfizer in 1849, and their trailing 20- to 30-year earnings and dividend growth rates were both stellar and steady, supporting the notion that all three were mature, stable growth companies several decades ago. The normalized earnings and dividend growth rates for several long-term periods are listed below:

Pfizer
Earnings: 1990-2002, 18.8%; 1994-2006, 18.4%; 1990-2006, 17.7%
Dividends: 1982-1994, 11.5%; 1992-2004, 15.7%; 1995-2006, 17.6%

Johnson & Johnson
Earnings: 1991-2003, 13.9%; 1994-2006, 14.0%; 1991-2006, 14.1%
Dividends: 1970-1982, 20.2%; 1980-1992, 13.6%; 1990-2002, 14.0%; 1991-2006, 14.1%

Medtronic
Earnings: 1991-2003, 21.0%; 1994-2006, 17.0%; 1991-2006, 19.6%
Dividends: 1982-1994, 14.1%; 1992-2004, 21.5%; 1991-2006, 19.6%

Each company posted double-digit growth in every decade-plus period listed here, and I think the consistency of their results is the most telling feature of the data. It suggests that these companies enjoyed persistent economic advantages and reinvestment opportunities that showed no signs of deterioration even many decades after the companies were founded. Because these were not young companies in the unsustainable rapid-growth phase of their life cycles, it should be reasonable to expect similar growth rates in the future as long as their economic advantages endure.

Economic Moats Intact
A company's return on its assets is a good measure of its economic strength, and I've listed the Pfizer, Johnson & Johnson, and Medtronic 1997-2006 averages below:

Pfizer: 14.7%
J&J: 15.9%
Medtronic: 15.4%

Most U.S. companies earn returns in the 4%-8% range, so the performance above is outstanding. The HCI portfolio companies have grown rapidly while earning returns well above their costs of capital, and they've done it for decades. That isn't typical in a freely competitive economy; most companies eventually earn no more than their cost of capital because rivals are attracted to above-market returns like sharks to blood. So how did the HCI portfolio companies do it, and more importantly, can they continue to do it?

First and foremost, I think their economic moats are based on technological innovation. Technological change is a threat to small companies with one or two cutting-edge products but limited resources to help them stay ahead of the curve. However, for companies with diversified product portfolios, an extensive R&D infrastructure, and a long history of new product development, technological change is a barrier that protects excess returns.

The HCI companies also possess valuable patents (e.g., Pfizer's Lipitor patents) and brand names (e.g., Johnson & Johnson's Tylenol) as well as sales and marketing prowess. Though sales and marketing skills aren't very "moaty," some companies seem to be more proficient than others year after year. Pfizer's salesforce was instrumental in driving Lipitor to a market-leading position even at a time when clinical trials (such as the Scandinavian Simvastatin Survival Study) supported preferential use of rival Zocor. Likewise, the Medtronic representatives I met as a practicing physician were generally more experienced and seemed to have more technical expertise than their competitors, and I preferred to work with them when I could.

Finally, all three companies have financial strength. They can obtain capital at attractive rates when it suits their purposes, and they aren't forced to access the capital markets when conditions are unfavorable. Therefore, they're in a good position to take advantage of reinvestment opportunities as they arise.

All of these attributes may whither and disappear over time, and I wouldn't be comfortable investing in Pfizer, J&J, or Medtronic unless their market prices discounted that event (they do). However, I don't see a fundamental change in the nature of any of these companies today, and I won't be surprised if they are still generating excess returns 30 years from now. After all, they're doing so 158, 122, and 58 years, respectively, following their inceptions.

In my opinion, they're unlikely to suffer a permanent deterioration in their economic characteristics except to the extent that adverse regulatory and legislative changes alter their operating environments. This may well occur as populations age and health-care spending grows as a percentage of GDP around the world. However, I think it is most likely that the changes will be gradual and slow.

Long-Term Average Valuation Approximates Fair Valuation
Ben Graham, the widely acknowledged father of securities analysis and Warren Buffett's teacher, wrote that the stock market is just a voting machine in the short run, but it is a weighing machine over the long run. In other words, stocks may be mispriced temporarily, but they will eventually reach their fair values.

I agree with Graham, and I think that 10 to 20 years is usually long enough to qualify as the "long run." Therefore, I expect Pfizer's, Johnson & Johnson's, and Medtronic's average valuations during the next couple of decades to match their average valuations during the last decade or two as long as their economic advantages are relatively stable and durable.

The HCI Portfolio Is Undervalued
The table at the link below contains average, maximum, and minimum valuation multiples from 1997 through 2006 for the HCI portfolio holdings. The three stocks are not just cheaper than average by these measures, they're cheaper now than at any time during the last decade. For example, J&J's recent enterprise-value-to-sales (EV/Sales), enterprise-value-to-EBITDA (EV/EBITDA), price-to-book (P/B), and price-to-earnings (P/E) ratios are lower than the minimum ratios during the trailing decade, and its dividend yield (Dividend/P) is higher than the maximum yield during the last decade. Click here to see the table:

A second table (see link below) shows current valuation multiples expressed as a percentage of the long-term average multiple with the exception of the dividend yield; there the historic yield is expressed as a percentage of the current yield. For example, Medtronic's recent EV/Sales ratio is just 62% of its long-term average, and its historical dividend yield is only 55% of the current yield. Both metrics indicate that Medtronic is cheap today--if its current outlook is about as good as its outlook during the last decade.Click here to see the table:
http://news.morningstar.com/articlenet/article.aspx?id=205869

What If I'm Wrong?
I think the very long record of superior returns at Pfizer, J&J, and Medtronic indicates deeply entrenched, structural advantages that will persist for many years, but I might be wrong. In particular, it's conceivable that sweeping adverse legislation could alter the economic characteristics of the health-care sector and permanently eliminate the excess returns earned by these companies.

As a practical matter, the U.S. health-care system is like a supertanker being pulled in many different directions by a variety of special-interest tugboats; it's difficult to change its course markedly in a short period of time, and when it is redirected substantially, it tends to drift back toward its original course later on. For example, the Balanced Budget Act of 1997 hurt hospitals, but subsequent legislation softened the blow, and legislation requiring the Centers for Medicare and Medicaid Services to reduce physician payment rates is superceded by stopgap measures every year. When the Clinton administration attempted a more radical overhaul around 1993 to 1994, the initiative failed.

In the unlikely event that significant and permanent adverse changes do occur within a short period of time, the HCI portfolio is protected by a wide margin of safety. For example, Medtronic is trading at a roughly 40% discount to its historical valuation, so if new legislation reduces its fair value by 40%, its subsequent return will be adequate. Further, the current dividend yields from all three companies are higher than their average yields during the 1993 to 1994 period; their current prices discount bad news that may never come.

Are the HCI Stocks Cheap Because of Legislative Risk?
Many market participants aren't so interested in the value of a company as in guessing where its stock price might go over the short term. I once had a conversation about investing with a managing director of sell-side research at a major bank. I talked about estimating the intrinsic value of companies as though I intended to buy the entire enterprise, and then purchasing shares when they could be had for less than my idea of fair value. He agreed that that was the sensible approach, but then he said that his clients (hedge fund and mutual fund managers) didn't care about such things; they just wanted to know where the stock price would be a few weeks hence.

Although the HCI portfolio stocks were market favorites throughout the 1990s, the action has been in small-cap stocks and highly levered, lower-quality companies of all types during this decade. Large-cap growth companies with sturdy balance sheets and high returns on capital went out of fashion during the 2000-2002 bear market, and so far, they haven't come back. The relatively low valuations of the HCI stocks may have more to do with momentum investors looking elsewhere than with concerns about the durability of economic advantages.

To the extent that other investors attempt to time short-term market movements or overweight short-term operating results, they provide investment-horizon arbitrage opportunities. I hope that the HCI stocks leap to their fair values tomorrow, but I'm willing to wait much longer than that because I'm confident that their compound annual returns will be attractive over the next decade.

The Market May Systematically Undervalue the Best Companies
Despite recent market fashion, the highest-quality companies tend to trade at a premium valuation to the broad market, and that makes sense, but how high is too high? In "Stocks for The Long Run," Jeremy Siegel examined the so-called "Nifty Fifty" stocks of 1972. Those were large-cap stocks with secure competitive positions that rose to seemingly high valuations by December 1972 before collapsing during the subsequent two-year bear market.

Despite the temporary collapse, Siegel reported that investors buying at the top in December 1972 would have done fairly well over the next 25 years if they simply held their positions. The Nifty Fifty stocks sold for 41.9 times their collective earnings at the end of 1972, while the broader S&P 500 sold for an 18.9 P/E. Despite that valuation handicap, the Nifty Fifty provided a compound annual return of 12.4% through June 1997 versus a 12.9% return to the S&P 500. Siegel calculated that Nifty Fifty investors would have matched the market return if they had paid a 38.6 P/E, more than twice the broad market multiple.

Pfizer and Johnson & Johnson were two of the Nifty Fifty stocks, and Siegel reported that their warranted 1972 P/E ratios were 54.9 and 56.8, respectively. In other words, Pfizer and J&J investors would have earned the same 25-year return as the broad market even if they had paid about three times as much for earnings. What is the current premium? Well, the S&P 500 trades for about 17.5 times earnings, roughly the same as J&J and Medtronic, and much higher than Pfizer. There is no premium today; it's been replaced by a discount.

The 1997-2007 results were similar to the 1972-1997 results reported by Siegel; high-quality companies like the HCI holdings warranted a substantial premium relative to the market. Pfizer, Johnson & Johnson, and Medtronic sold for average P/E ratios around 33.3, 24.9, and 37.9, respectively, in 1997 versus an S&P 500 P/E around 22.4. The trailing 10-year total return to the S&P 500 through Aug. 31, 2007, was about 4.6% versus 4.5%, 10.0%, and 9.3% to Pfizer, J&J, and Medtronic, respectively. As a group, these three outperformed the S&P 500 handily despite their premium prices.

Given the discount prices available today, I'm optimistic about prospective returns.

Portfolio Construction
The HCI portfolio contains three stocks today, but I'd prefer to own 1,000 stocks, all equally attractive. That way, I wouldn't have to worry about significant adverse surprises at any one company. If researchers discover that Lipitor induces fatal cancer 10 years after ingestion, then Pfizer's value will collapse on the day of the announcement; not a disaster if Pfizer is one stock in a thousand, but big trouble if Pfizer is more than one-third of the portfolio.

Diversification protects investors from highly unlikely company-specific events. Investing is based on probabilities, and like casino owners, good investors shift the odds in their favor. If I bet you $1 on the outcome "six" for every roll of a die, and you paid me $5.50 when I won, then I would eventually come out ahead. However, it wouldn't be unusual for me to lose three games in a row (5/6^3=57.87% probability). It's still a good bet. It just isn't a safe bet unless I can make it repeatedly.

Unfortunately, I haven't found 1,000 attractive stock investments, and diversification for its own sake can "protect" investors from above-average returns. As a practical matter, I doubt that I'll ever have more than 20 good ideas at one time, and I would be fairly comfortable with 10 to 15 stock positions, weighted according to my level of confidence in each one. Still, it may take me quite a while to find even 10 good ideas.

In the meantime, I think it would be unwise to put all of your funds in just Pfizer, J&J, and Medtronic. For that matter, there is no reason to limit your investments to the HCI portfolio selections even when it is fully invested. I expect to generate an attractive absolute return over the long term, but there are undoubtedly equally good investments beyond the health-care field, and to the extent that you can find them, you'll be better off if you spread your holdings around.

The important caveat is "equally good." I wouldn't invest my funds without regard to the attractiveness of the investments; a limited number of well-chosen positions is usually safer than a little bit of everything, in my opinion. Nevertheless, even I don't restrict my personal funds to health-care stocks.

Performance Evaluation
The cash in the HCI portfolio complicates your evaluation of my performance because its low yield drags the portfolio return lower and understates my stock-picking ability. You could look only at the return to the invested portion of the portfolio, but that is being a little too kind to me. After all, I could invest the entire portfolio in the three stocks I hold, but I don't do that for the reasons discussed above. I want the benefit of the cash position in case one of my holdings suffers a six-sigma disaster.

There is a third way to evaluate my performance that solves the cash problem, albeit at the cost of creating a new one. If I ran a health-care stock fund for a mutual fund company, and my mandate was to outperform some investable health-care stock benchmark, then I would hold that benchmark in the fund in lieu of cash, and sell it off in pieces to fund my stock ideas as I developed them. In that way, any difference between the portfolio performance and the benchmark would be due to my stock picks alone.

You could evaluate my performance in that context by substituting the return of the U.S. OE Specialty-Healthcare benchmark for the cash return in the HCI model portfolio. I'm adding value as long as the return to the invested portion of the HCI portfolio exceeds the benchmark. There are also three exchange-traded health-care funds that I track internally, Health Care Select SPDR (AMEX: - ), iShares S&P Global Healthcare (AMEX: - ), and Vanguard Health Care ETF (AMEX: - ). They are investable benchmark alternatives for real-money portfolios, and I'll send you the returns by e-mail if you're interested.

I don't invest the HCI cash in the benchmark because my primary goal is to generate an attractive absolute return of CPI + 5% or more; beating the indexes is a secondary goal. If I were confident that the benchmark would achieve my primary goal, or even that it would beat cash, then I would use it. However, I can't readily evaluate the prospective return to the benchmark, and I'm unwilling to trust that it will beat cash as a matter of faith.

Therefore, I suggest you evaluate my performance according to your point of view. I suspect most readers will want to use HCI stock ideas in the context of their diversified portfolio of assets; that's how I use them for my personal portfolio. If that is the case, then it would be most appropriate to grade my performance by comparing the return on the invested portion of the HCI portfolio against the CPI + 5%. That's how I grade myself, though I'll be disappointed if I can't beat the CPI + 10% over the long run.

I believe that CPI + 5% will turn out to be a tougher standard than the return on the broad market as represented by the Rydex S&P Equal Weight fund, but it would also be reasonable to compare the return on the invested portion of the HCI portfolio to that benchmark.

On the other hand, perhaps you've decided to hold a certain portion of your assets in health-care funds, and you're wondering whether you should put that money in my stock picks. You could create your own fund by substituting a health-care ETF or actively managed mutual fund for the cash in the HCI portfolio while putting the remaining funds in Pfizer, J&J, and Medtronic. If so, you'll want to compare the return on the invested portion of the HCI portfolio to your next-best alternative, your favorite health-care fund or ETF.

Finally, the cash isn't a deliberate market-timing device, but if the market collapses, it will be easier to identify good investment opportunities and the HCI portfolio will fill up much faster. The cash would help the HCI portfolio performance in that setting, so it's reasonable to ding me now while I'm looking for bargains and the cash return is hurting performance. Ultimately, I'll give myself an F if the entire HCI portfolio (invested portion and cash) falls short of CPI + 5%, but that is a long-term goal that faces a shorter-term hurdle--finding enough good ideas to fill the portfolio.

Click to see the HCI Portfolio table:

Curt Morrison, MD, FACC, CFA, has a position in the following securities mentioned above: JNJ MDT PFE