176 The World of Contrarian Investing 2. Eli Lilly

As I wrote in my Forbes column of March 29, 1993:

A major oversold situation is beginning to become apparent in the pharmaceutical stocks, which were knocked down 5 1 last year and have continued their decline since the Presidents State of the Union message.

No question, the pharmaceuticals are under heavy investor fire and the pressure will probably get worse. I would be su rised if the drug industry didnt trend lower from here.

1 recommended a number of drug stocks, continuing, "All have low P/Es, conservative earnings estimates, strong balance sheets and above-average yields." The group sha ly outpaced the rapidly rising market.

Lets look at Eli Lilly, recommended at $12.75 in that column.* "Eli Lilly," I continued, "has been battered both by negative psychology on drug stocks and by lower-than-average near-term new-product development .. . eamings should be up from 1992. The stock trades at a P/E of 8 times 1992 estimates and yields 4.7%."

Lilly is one of the nations largest manufacturers and marketers of pharmaceuticals and health-care products. Not only did the company have a low P/E, but it had an excellent record of eamings and dividend growth. They grew at compounded rates of 18% and 17.1% respectively over the previous five years, gaining high marks by indicators 3 and 5.

Moreover, indicator 1 was off the charts. Its debt-to-total-capital ratio was 10%, against 55% for the S&P 500, and its working capital ratio, too, was very high. To continue the checklist, Lillys retum on equity (ROE) was a staggering 28.5% in the previous year, and had averaged 27.1% over the previous five years, almost double the average large company. Its net profit margin, another important financial ratio, averaged 22.5% over the previous five years, again about double the percentage of the average company. Other ratios were also very strong.

Even the worst political scenario for the stock would envision above-average eamings growth, albeit at a lesser rate than in the past. Moreover, the fears of the dmg pipeline mnning dry are as old as the hills for large pharmaceutical companies. Because of their enormous research and development budgets, most, including Lilly, have scads of products in the pipeline.

Analysts looking only at near term blockbuster products frequently forget this. Lilly tumed out to be no exception. Prozac, the antidepressant, caught fire, and is continuing to expand its sales, including a mar-

Figure 8-6

Eli Lilly & Co.

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12/95

Source: Prepared from FactSet data

ket for depressed toy poodles, whose quality of life has seemingly been significandy improved by its prescription.

The stock seemed definitely unde riced. As my article warned, it went lower that year, dropping to $11 or another 14%. But as we saw in chapter 3, market timing is difficult if not impossible. It then rallied to $70 by the end of 1997, appreciating 449% from its recommended price. (The total retum was 565%.)

Note that, although I used a conservative estimate, as per indicator 4, it tumed out too high by 15%. Yet the negative eamings su rise was shrugged off by the market, which, as we saw in chapter 6, is normal for low-P/E stocks.

Here was the classic GAR? double play, both above-average eamings growth, and a major expansion of its VIE multiple, as Figure 8-6 indicates. And what is GARP, you ask? This gives me the opportunity for a litde aside on a well-kept secret.

Using Low Price-to-Cash Flow

3. Ford

Low price-to-cash flow, as Figure 8-2 demonstrated, had well-above-average retums over time. Price-to-cash flow is often a more useful measure than earnings when a company has large noncash expenses.

The World of GARP

For a value manager, disclosing it is a little like emerging from the closet as an efficient market believer. But, here goes-growth and value are not always poles apart. In fact, sometimes you can fit a tasty growth entree into your portfolio-if you dont pay too much for it.

The Street terms this strategy GARP-Growth at a Reasonable Price. Although this definition can cover a wide range of growth stocks, some with prices in the stratosphere, it has proven very successful when used within a low-P/E strategy.

If you buy a GARP stock, you have the chance of a double play. First, above-average eamings and dividend growth, which should result in its outperforming the market, even if the P/E remains constant. But you also have a fair chance to make the second half of the play-an expanding P/E ratio, if the above-average growth continues.

How do you find a GARP stock? There are a number of ways. Often growth stocks will have temporary negative news that sends them plummeting, although their basic outiooks are still good. A good example was the Clintons confrontation with the pharmaceutical and health-care companies in 1993, that we just looked at. Investor fears that the healthcare industry faced a dire future sent many of these first-rate stocks tumbling, often collapsing P/Es to half of previous levels. Pharmaceuticals traded at P/Es of 8 to 14, bringing the industry into the low-P/E camp. Here was an excellent case of GARP, ripe for the picking. With low P/Es, yields between 4.5% and 6.5%, and growth, even in a worst case, well above the S&P 500, the stocks proved to be a screaming buy, doubling in less than two years.

GARP opportunities come around more often than you might think because of eamings disappointments, fears that knock down entire growth industries, and many other market overreactions. A good GARP situation allows you the possibility of a home mn, while staying safely in the value camp.