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Stock Strategist

Three Once-in-a-Decade Stock Values

These HealthCareInvestor stocks haven't been so cheap for more than 10 years.

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My investment theses for HealthCareInvestor portfolio holdings  Pfizer (PFE),  Johnson & Johnson (JNJ), and  Medtronic (MDT) share common themes and depend on the following assumptions:

  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 curt_morrison@morningstar.com to discuss a point, ask a question, or say hello; I enjoy the correspondence. Also, if you'd like to receive free, real-time e-mail alerts when I make a transaction or write a supplemental report, please register through this link. I sent a supplemental e-mail report Tuesday Sept. 4 covering breaking news from the European Cardiology Society meeting regarding drug-eluting stent safety. If you'd like to receive it, just let me know, and I'll send you a copy.

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
  1990-2002 1994-2006 1990-2006
Earnings Growth (%) 18.8 18.4 17.7
  1982-1994 1992-2004 1995-2006
Dividend Growth (%) 11.5 15.7 17.6

 Johnson & Johnson
  1991-2003 1994-2006 1991-2006  
Earnings Growth (%) 13.9 14.0 14.1  
  1970-1982 1980-1992 1990-2002 1991-2006
Dividend Gr  (%) 20.2 13.6 14.0 14.1

 Medtronic
  1991-2003 1994-2006 1991-2006
Earnings Growth (%) 21.0 17.0 19.6
  1982-1994 1992-2004 1991-2006
Dividend Growth (%) 14.1 21.5 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.

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Curt Morrison has a position in the following securities mentioned above: JNJ, MDT, PFE. Find out about Morningstar’s editorial policies.