Old School Value

After my post on when to sell stocks last week, we have a guest post from fellow reader Tim du Toit, the editor of EuroShareLab, to discuss his methods of selling. Since selling is a difficult aspect of investing, I encourage you to read the following post by Tim.

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Introduction

I always thought of myself as a long term buy and hold investor. Buying good companies and holding through thick and thin thinking that overall my investment performance will be acceptable. But looking at my portfolio over time I realized that I developed the tendency of selling winners and hanging onto losers. Try as I may, I found it really hard to rationally break away from this tendency.

After a lot of research I developed a strict selling strategy which has helped me a lot and I hope it helps you too. If nothing else I hope this article prompts you to think about your approach to selling and how it can be improved.

Important Points

• You should have a selling strategy
• You should have it written down
• You must review it regularly
• You have to force yourself to follow it

Why is it important to limit losses?

Limiting losses is very important as the gains required to recover the loss grows exponentially as the loss gets larger.

The following table and graph show the relationship between a loss and the recovery visually.

Whatever approach you take to selling, this is the most important principle to bear in mind, irrespective of how positive you are on the recovery probability when it comes to the losing investment in your portfolio.

Behavioral aspect of selling

Fear and regret play a large role in investors failing to sell a stock that has declined. Sometimes when a stock falls, it’s a great opportunity to increase the investment at an even more attractive price. But in cases where investors have made an obvious mistake, and logically should sell immediately, behavioral research shows that they will often hang on, thus suffering even greater losses.

Why is this?

By selling, they have permanently locked in the loss, and then have to confront the pain and regret of having made a bad investment, including the potential embarrassment of disclosing the loss to others.

Somehow, in our minds, we think that our ownership of something increases its value. This is incorrect. For example, just after placing bets, punters at the racetrack become much more confident about their horse’s chance of winning the race. Similarly, lottery ticket buyers tend to buy more frequently if they are allowed to choose their own numbers. Investing in shares is no different.

So what can we do to avoid costly and annoying errors?

• Approach investment decisions from as neutral a position as possible
• Ignore all sunk costs by ignoring the cost of the investment when reviewing your portfolio
• Accept it as inevitable that you will make mistakes in your buying decisions
• You will face tremendous pressure that will tempt you to rationalize your mistakes and not correct them
• You will tend to protect the status quo by inventing new reasons to hold on to a bad investment
  • This will be especially true when your original buying decision is known to many other people who are important to you, as it will hurt you to acknowledge this to them, and to yourself.
  • It will be difficult for you to correct the mistake because you will attach more importance to saving face by appearing to be consistent with your past commitments.
• Don’t overvalue your current positions. Pretend that you don’t own them, and ask, “If I didn’t own this stock today, would I buy it?” If the answer is no, you should think hard about selling.
• Don’t compound past mistakes for fear of embarrassment. In the end, the best advice is to learn from mistakes and move on.

Selling Stocks to Realize a Gain

1. Movement of the share in the ranking

If you buy stocks based on a ranking or a mechanical strategy, such as a low price to earnings ratio, low price to book ratio, or high dividend yield, the movement of the stock from cheap to expensive through the ranking can be used to determine the selling point.

2. When your premise is fulfilled

This is what it is all about - selecting a share because of a reasoned, well-thought investment premise, and things work out exactly like you expected, or better. When this happens you have every right to feel confident and take your well earned profits.

3. After a substantial rise in price

Another reason for selling is when you think the stock has become more valuable than it should be. Unfortunately, for many of us, the realization that a stock price has increased too much comes long after the price has already peaked and started to fall.

4. When it doubles

An old adage in the market is that you should sell half your holdings when a stock doubles. This is a purely emotional reason to sell a stock. It allows you to feel like you have received all of your money back and that the money you now have in the share is pure profit or “house money”. The concept of “house money” is purely emotional as all the money, including the gain, is always all yours.

Selling Stocks to Limit a Loss

1. Your reason for making the investment

Once you have done your homework on a company, write down your concise reason for buying.

Should you use this selling strategy, you may want to implement a strict rule that if you were wrong about the reason for investing, you should exit the position with no questions asked. Never invent new reasons to hold a position when the original reasons are no longer applicable.

Holding onto a position simply to recover your initial capital is usually a recipe for even greater losses.

2. Leave emotions out of it

Should it happen that management really makes you angry, you may want to put the investment away for a while and not do anything. Try not to take action just because of your emotions.

If you take action because of an emotional reaction, it is likely that a lot of other investors are thinking exactly the same. This means that everyone is abandoning the investment at exactly the same time. I have found it better to wait a while, even if I am still angry.

3. When your nerves can’t take it any more

Have you ever bought a stock that has taken you for an emotional roller-coaster ride? Instead of increasing in value the price dips and bounces every day. If holding the stock makes you so uncomfortable that you can’t sleep and you only worry about how much money you have lost or made in a single day, you are being distracted.

4. Percentage drop in price

This strategy is the simplest of all, but also much more difficult to implement than it looks. Sell after a fixed percentage decline in price. This level can be set by looking at the recovery table mentioned above, or can arbitrarily be set according your pain threshold.

My Approach (Tim’s)

Below is a diagram of my approach to selling. It’s a combination of the many considerations mentioned above.

Click to enlarge

The loss and gain levels are arbitrary, but they are ones I feel comfortable with. You can use it as a basis to build your own selling strategy. Even though I have developed it and feel comfortable with the arguments and values, I still find it difficult to stick to. The toughest decision is to sell according to the model when I think the share is down due to a negative day for the stock market overall, or negative industry news. The most frustrating is when I did not sell at a 25% loss and the loss then increased to 33% or more.

How the Stock Selling Model Works

Loss of more than 16%

If the share price declines more than 16%, I first ask if I have already added to the position. If not, I redo the analysis. If the business has not deteriorated in one of the five factors mentioned, then I buy more after selling the position to make use of any tax losses. The position is never a hold - either I buy more as the investment has become more compelling, or if it has not, I sell.

Should I have increased my position, the loss on the new total position would have decreased as my average purchase price has declined.

Should my loss again exceed 16% after I have bought more shares, I ask a friend or fellow investor to redo the analysis. I use this objective review to determine if I have missed anything in my analysis. Should the independent evaluation come to the conclusion that it is a good investment, I may buy more or I may just hold, depending on the size of the position in my portfolio.

Loss of more than 25%

In order for a loss to exceed 25%, I would have had to go though my own, and an independent, review of the position when the loss got to 16%. At this point I cut my losses. I may be wrong in selling but I can always buy the shares again.

Selling at this point has enabled me to get out of a position where it has later shown that something was happening in the market or with the company, that I did not understand.

Gain of more than 50%

Should my gain on the investment exceed 50%, I also review the position. If the investment was a “Cigar butt”, a description Benjamin Graham gave to cheap, bad quality businesses, I exit the position as the lowest risk gains have been made.

If the investment is a high quality business, I determine if the gain has been purely price-based with no change in the earnings of the business. Should the former be the case, I may sell right away, or may still hold if the valuation is lower than the market or peer group based on price to earnings ratio, for example.

Should the earnings of the investment have increased along with the price, I will hold the shares.

As you can see, my approach to selling is mainly sticking to the “rules”, but it allows some decision freedom. What I really try to stick to is the hard rule of selling out at a 25% loss.

An Example

About a month after I bought Dell Inc., the share price fell 17%.

The following day I looked at my financial analysis and made sure there were no updated financial or recent news I was not aware of. I found nothing, apart from uncertainty around worldwide computer shipments in the coming year. I added to my position.

This lowered my loss to 11%, as my average purchase price was lowered by the additional shares. About six weeks later my loss again exceeded 16%.

This time I asked a friend to work through my financial analysis to see if he found the company an attractive investment. Apart from a few points he also thought it an attractive investment. I decided to hold the position and not buy additional shares.

Three weeks later my loss on Dell exceeded 25% and I sold the position. From what I could gather the share price decline was caused by weak sales results by Lenovo Group, one of Dell’s competitors. Having sold the share I was in the position to objectively and unemotionally evaluate what I wanted to do from there going forward - repurchase the share after waiting for the situation to stabilize, or look for alternative investments.

What happen?

Dell’s share price recovered slightly after I sold, but subsequently went on to lose a further 20%.

The sale thus had a good outcome, but even if the share had recovered I would have been pleased as it limited my losses and gave me complete emotional freedom to evaluate my options.

Summary and Conclusion

The goal of  this article is to show that it is important to think about your selling strategy in advance of making your investments, and to make it clear that selling is a lot more difficult than it looks.

To summarize the most important points in this article:

1. Have your selling strategy written down.
2. Look at it often.
3. Make changes as you gain additional insight.
4. Stick to your selling strategy – no exceptions!

I wish you all the best with your investment endeavors.

Tim du Toit

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The purpose of EuroShareLab is to share knowledge and ideas gained in over 20 years of investing experience and continuous learning to help other self directed investors on their investment journey.

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Our guest post today is courtesy of Manshu Verma from OneMint, a website with the vision of “creating wealth for everyone”. If you like this article and wish to read more about the economy, stocks, investing, credit cards or other topics on personal finance, please consider subscribing to this feed.

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A lot of people invest in commodity mutual funds and ETFs because of the convenience these funds offer. A large number of investors use these funds as a proxy for holding the commodity itself. After all, how many of you want to hold barrels of oil in your backyard?

If you own a commodity fund and expect that fund to hold the underlying physical asset — this may not always be true. There are different type of Commodity ETFs that track the price of the underlying assets in different ways.

Funds that Own the Physical Assets

ETFs like iShares SLV own the physical quantity of silver that the fund represents. These type of funds actually own physical silver, gold, oil etc. and then issue units against those.

If you are buying a commodity fund only because you don’t want to directly own the underlying asset — these type of funds offer you the closest proxy.

Funds that Own Futures Contracts

ETFs like the Power Shares DB Funds don’t own the physical underlying commodity at all. These funds enter into Futures Contracts and create strategies such that the price of the fund behaves in sync with the price of the underlying asset. Normally, such funds track the movement of an underlying Index, which in turn is designed to track the movement of the prices of the underlying asset itself.

These funds hold short term credit instruments and US Treasury units in addition to the futures contracts. Such instruments enable them to earn interest income which can be then used to cover their expenses.

Funds that Own Mining Stocks

Then there are ETFs that hold stocks of companies that deal in the underlying assets. These are funds that own stocks of gold mining companies or steel mills etc. They don’t own any physical asset at all and are purely invested in stocks of the underlying companies.

Exchange Traded Notes

ETNs are often mis-understood to be an equity instrument, these are really debt instruments and depend on the solvency of the bank or financial institution that issues them.

Proxy for Physical Assets

If you are just looking at buying a fund that holds the physical quantity of the underlying asset for you — then you should get into the first category of funds described here.

Personally, those are the only funds that I prefer. Why pay someone else for a futures contract that I myself can enter into and why pay someone else for owning a stock that I can buy directly? As for ETNs, they are not an equity instrument at all, so the question of being a proxy for physical assets is really remote.

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The following is a guest post by Daniel at the Guru Five

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Berkshire Hathaway is a well-capitalized group of diverse companies whose free cash flow is ably managed by the world’s greatest investor. However, the price of a share of Berkshire has declined by roughly 40% of late, wiping out years of gains. Is “buy and hold” dead?This question seems to get asked every time a period of bad performance is turned in–whether by one’s managers or by oneself. And, not surprisingly, the time frame for those who say “buy and hold” is dead–or should be–without fail is unjustifiably short.

Consider Berkshire. At 92,000 for a share, the price to own that much of the company has done all of nothing for the past three years. This is something new–right? It’s something that requires you to rethink finding a great company at a good price and then sitting on your hands and doing nothing–or is it?

In the lead-up to this year’s shareholder meeting, almost every journalistic introduction stated that this event would be more sober than in year’s past. After all, they said, shareholders have been used to the steady growth of Berkshire–year after year, without fail.

Consider though: periods of a company’s stock price not going anywhere for years is not something that just started over the past two. Not even for Berkshire.

For example, the stock price did nothing from around 1998 to 2003. Five years and nothing to show for it! Then, too, shareholders and journalists were asking: “Is ‘buy and hold’ dead?”

In actual fact, the “buy and hold” strategy is not dead–and should not be–it simply depends (as it always has) on what it is you are holding and the relation of its quoted price to what it is worth.

As Berkshire shareholders for the most part know: periods of underperformance come and go, but if the business is great, the prices paid for them good, and the cash they throw off invested accordingly, the market price will catch up with the growth in underlying business value at some point.

Rather than ask whether the “buy and hold” strategy is dead, asking how to find the companies that can be held long-term is sure to give a better answer.
Then, once you find them, it’s mostly a matter of finding out whether the company’s selling at an attractive discount from intrinsic value. (Given this environment, I’d guess that you’ll be in luck.)

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Today we have a guest post by Daniel Rudewicz, who is the co-founder of Furlong Samex LLC, a deep value investment partnership based on the principles of Benjamin Graham.

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In November 2002, current Fed Chairman Ben Bernanke (then Fed Governor) gave a speech before the National Economists Club, Washington, D.C. titled: Deflation: Making Sure “It” Doesn’t Happen Here

The speech in its entirety can be read here: http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

While we do not base our investment decisions on the actions of the Fed, I had previously read this speech on deflation a few months ago and found it an interesting reread. After Tuesday’s announcement the Fed announced it would purchase an additional $750Billion in agency MBS and $300 Billion of long-term Treasuries. When I reread the speech it seemed as if the is speech was a playbook of sorts for Bernanke and his efforts to prevent (or cure) deflation. Bernanke makes the argument that the Fed is not out of tools to fight deflation once the Fed Funds Rate has reached zero. He gives us an insight into what tools he would use to prevent and cure deflation. Below we examine what he has used so far and what may be next. (Below, we have selected small parts of the speech and - if the reader is interested in Bernanke’s thoughts on deflation - recommend reading the full speech posted on the Federal Reserve’s website.) In the “Curing Deflation” section of his speech he highlights the following ways to cure deflation:

“Under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.”

“The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

“To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.”

“Alternatively, the Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities.”

“One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities.”

“Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).”

“If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities.” [Emphasis mine]

Author’s note: although the current actions of the Fed could be construed as influencing the yields on privately issued securities, the word directly persuaded me to believe that they have not done this yet. To my knowledge they have not engaged in activities similar to Tuesday’s announcement, where they have purchased privately issued securities to directly affect the yield. Although they have provided backstops in the case of Bear Stearns and also assisted the commercial paper markets, it was not for the purposes of lowering yield. I have left it blank but others may disagree.

“The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt. I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar. Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it’s worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt’s devaluation.”

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If you enjoyed this article and have any questions, you can reach the author at rudewicz@furlongsamex.com

This is a condensed public version of Taking Stock in Pfizer (PFE) stock analysis made available via subscription to SAML subscribers. The full analysis, in PDF form with all accompanying data, can be purchased by readers. Visit TMWTFS for more details.

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A ‘Critical’ Analysis:

(Available with full version)

This segment contains an introductory discussion of Pfizer’s strategic dilemma in handling c and what readers can identify as important fundamental themes during the stock analysis.

Company:

Pfizer is a global research based pharmaceutical company with a long corporate history dating back to 1849. The company strives to demonstrate that their products effectively prevent and treat targeted diseases, improve symptoms and suffering and that the company helps to form the basis for improvements in the healthcare system.

The corporate goal of the company is in “Developing medicines that meet medical need and that patients will take; that physicians will prescribe; that customers will pay for; and that add the most value for Pfizer.”

The company has a large portfolio of established drugs and operates globally in both developed and developing nations with a key focus on emerging markets. In 2007 the company published a number of key focuses that are targeted to improve business operations and increase shareholder value moving forward:

• Maximize short and long-term revenues
• Establish a lower and more flexible cost base
• Create smaller, more focused and more accountable operating units
• Engage more productively with customers, patients, physicians and other collaborators
• Change business operations to focus on shareholder value through growth of revenue and income
• Refocus and optimize patent-protected portfolio for new opportunities
• Create a culture of continuous innovation
• Investment in complimentary businesses
• Remain focused on pharmaceuticals & biotechnology (biotherapeutics)

In 2007 management began focusing on lowering their cost structure by reducing the number of employees across the company by 11,000. The company repurchased $10B in common stock for cancellation and began to aggressively push Phase II compounds into Phase III trials.

The majority of Pfizer’s current revenues are driven by a large group of established patent-protected medicines that in recent years have come under threat from lawsuits, patent expiration and generic competition. Lipitor, their flagship product, competes in a very competitive statin market (cholesterol lowering) and will lose its patent protection in November of 2011 when Ranbaxy is allowed to a sell generic version of the drug for a six month period.

The company has also set a number of commitments on a strategic management basis:

• Optimize product portfolio & accelerate product pipeline
• Establish smaller units of operation
• Expand into emerging markets
• Capitalize on established products
• Align cost structure with revenues
• Attain ambitious cashflow targets
• Refocus on capital allocation to maximize efficiencies

Drug/Clinical Development:

Before I go further into the situational analysis I want to provide readers with some background education on drug trials and clinical development in order for you to be able to put into perspective what Pfizer is currently doing and how successful they may/may not be with their ambitious plans.

There are a few key concepts I want to present first for each reader to keep in mind when analyzing any pharmaceutical company. The most important fact to be aware of is that every drug has a commercial lifecycle. A drug is born in the lab and progresses through clinical trials after which regulatory approval is required to sell to the public. A drug grows through exclusive marketing rights provided to a company and years later its’ patent protection expires where generic competition erodes revenues and margins. Clinical trials compose nearly 60% of total development costs in today’s market and the capital required for funding these programs has accelerated significantly over the past two decades.

A new drug is developed through a series of trials where the objective is to assess the safety of the compound in an environment of very high scientific standards. Through the entire process there is a massive amount of red tape that a company must go through in preclinical testing to advance the drug to clinical testing. Even once a drug makes it to a clinical phase there are numerous review boards and ethics committees who evaluate the danger to participants, the ability to obtain informed consent, methodology of the trial design and strict monitoring of participants for adverse side effects.

Phase 1
In this first phase an investigational drug is administered for the first time to humans after successful trials on animals. This clinical trial is focused on the safety and tolerability instead of the effectiveness of the drug and determines the pharmacokinetics (what the body does to the drug) and pharmacodynamics (what a drug does to the body) in a small randomized population. Investigators assess each participant’s response to the drug, absorption within the body, length of availability in the blood stream and what dosage levels are considered safe and well tolerated.

Phase 2
In the second phase the focus of the trial is to determine the effectiveness of drug in treating an illness or identified medical condition. Data on the safety, side effects and potential risks is collected and researchers work to determine the most effective dosages (tablet, extended release, controlled release, infusion, injection). This trial involves a larger number of participants; this time with participants who have the medical condition that the drug is intended to treat. This is the first stage where a placebo is introduced to determine environmental effect of the trial on participants.

Phase 3
The third clinical trial focuses on testing a larger population. This trial is randomized and has a double-blind approach where neither researchers nor participants know if they’re taking the drug or placebo until after the trial ends. This trial is considered long-term since participants are involved from six to twenty four months. Researchers take a more geographical approach by taking participants in different environments to further test the impact of the drug.

Registration
Before a drug can move on to the final clinical trial phase an application needs to be filed with the regulatory health authority. In the US a new drug application (NDA) is filed with the Food and Drug Administration (FDA). A description of the manufacturing process of the drug along with all collected data and results from the previous clinical trials must be provided to the FDA so they are able to determine the safety and effectiveness of the new medicine. If approval is granted, the new medicine can then be sold for use by patients. Only 20% of drugs entering phase one clinical trials ever make it to the registration phase.

Phase 4
The final clinical trial is conducted after the regulatory approval of the drug has been received and is available for sale to patients. This final trial is where researchers collect additional information about long-term side effects, health risks or alternative benefits for other uses and continue for a number of years.

Situational Analysis:

(Available with full version)

This prized segment contains a strategic analysis of Pfizer’s internal strengths, weaknesses, opportunities and threats as well as external political, economic, social and technological challenges.

Management:

Assessing management through a period of stagnating performance or restructuring is always a difficult task because choosing a set of effective evaluation criteria for the challenges facing a corporation are never easy to quantify. It is easy for a CEO or strategic stakeholder to announce cost cutting initiatives, that they are actively pursuing a change in the corporate culture or where the company expects to be. But a corporation will always encounter problems in its operations and these will need to be met swiftly and decisively with management keenly aware of emerging problems before they become public knowledge.

When evaluating management through a restructuring period an investor needs to remind him/herself that financial performance will only be visible once the restructuring is completed and the company finds itself on the other side. An investor can choose to invest in a company now or wait for a period of time to see if changes being made will effectively benefit the corporation over the long-term. My number one priority, when assessing any management structure, is to answer the following question: Does management have their fingers on the pulse of the business?

Management needs to focus on achieving meaningful leadership within their organization. Achieving results on their own will not be enough to save a corporation and secure the long-term viability of a business; management needs to achieve results through others. In a top-down approach management needs to have the ability to empower employees, make strategic decisions that fit the business model and focus on profitability while continuing to operate the business effectively.

When current CEO Jeff Kindler joined Pfizer in 2002 the company was suffering from corporate obesity and critical mass. Jeff Kindler has a background in law (Harvard Law School) and comes from a strong operational background as Vice President at both General Electric (GE) and McDonald’s (MCD) before he became CEO of Pfizer in July of 2006. The fact that he was chosen as CEO over more tenured management within Pfizer signalled, in my opinion, the Board of Directors understanding of the level of importance for the corporate leader to understand patent and legal issues facing the company and the need for a fresh perspective on the future of the business.

Pfizer’s veteran management team has an average 18 years of experience within the company with many having a solid education and work experience in the medical field. Under normal circumstances experience of this level within the management ranks would provide soothing comfort to a prospective investor. In my assessments of Russel Metals (RUS) and Manulife Financial.

I highlighted the need for senior management in predictable and stable businesses. In a sector such as healthcare that requires a commitment to innovation, achievement and fresh perspectives to maintain a competitive edge in a rapidly changing industry an average of eighteen years means the company has a lot of experience and wrinkles.

The pharmaceuticals industry is changing, sometimes with drastic movements, and investors need only to look to a competitive analysis to determine the lagging performance of many within the group. Reshaping the top 100 leaders of the business to reflect a balance between new and veteran leadership is an admirable goal. But when I assess the senior management of the company and look for innovative leadership or individual who can think outside the established framework to influence the corporate culture of Pfizer I don’t find what I would expect to see.

A serious concern I have with the extent of cost cutting and job losses at Pfizer is the preservation of the corporate culture. When you look back ten years Pfizer was a company that thrived on the successful development of many important compounds found in the drugs they develop and market today. Their productivity within their R&D divisions was unrivalled amongst their peers, but as the company grew through acquisitions and attempted to integrate multiple corporate cultures into their own a number of key resources were lost that were vital to the success the company had enjoyed for so long. Redefining and motivating any corporate culture devastated by job losses, cut backs and significant change is not an easy task and each has a direct effect on the productivity of employees in executing the objectives of the company. Many of the leaders within the company were present during the ugly integrations of previous mergers and the end result, in my view, will continue to be the same without a dramatic shakeup.

No employee can work productively with multiple managers and repetitive oversight of their tasks and the ratio of employees to managers in recent years at Pfizer has swelled at the bottom to as high as 13:1.

Competitive Analysis:

(Available with full version)

This segment contains a discussion of Pfizer’s competitive environment, forecasted industry market share/growth for 2009, market conditions and list of direct competitors with disclosure of what I own in the healthcare industry.

Restructuring:

Pfizer has been in a restructuring phase for a few years now and decided to refocus its product portfolio prior to its Wyeth acquisition.

Pfizer’s new focus will target therapies for Alzheimer’s, Diabetes, Inflammation/Immunology, Oncology, Pain, Psychosis, Asthma/Chronic Obstructive Pulmonary Disease (COPD), Genitourinary, Infectious Disease and Ophthalmology.

Pfizer is exiting drugs and shelving R&D on new compounds for Anemia, Atherosclerosis/Hyperlipidemia, Bone Health/Frailty, Gastrointestinal, Heart Failure, Liver Fibrosis, Muscle, Obesity, Osteoarthritis and Peripheral Artery Disease. The exit from atherosclerosis/hyperlipidemia is surprising considering Pfizer’s dominant position in that market with Lipitor and demonstrates the perceived lack of profitability present. When Lipitor comes off patent Pfizer is expecting a significant decrease in sales of the drug and likely with the exit of professionals who worked on the Lipitor project from the company the intellectual gap was significant enough to warrant exiting that area of expertise. Additionally statins are a group of drugs that are expensive to manufacture and profit margins may be too slim in a generic environment for the company to see any viable reason to remain in the market.

Pfizer has also concentrated on selling non-core assets as best as it can with the sale of its consumer health division to Johnson & Johnson in 2006.

The failure and subsequent abandonment of Exubera is disappointing for the company as Exubera was the first inhaled insulin therapy for the treatment of diabetes developed. Despite launching in Germany, Ireland, the UK and US in 2006 the financial performance of the drug accompanied with the lack of adoption by patients and physicians led to an exit strategy for the drug. The fact that Pfizer was unable to sell the drug and technology to larger diabetes drug companies such as Novo Nordisk was another strategic opportunity missed by the company to recoup some of the costs in developing the drug and delivery technology. Pre-tax charges amounted to over $2.8 billion in 2007 at a cost of 5.8% of total 2007 revenue.

Pfizer’s did attain achievements in 2008 of advancing 14 drugs to Phase 3**. The company currently has a target of placing 24-28 drugs in Phase 3 by end of 2009 and submitting 15-20 drugs by 2010-2012 for approval.

** On February 24th Pfizer announced it was discontinuing development of two Phase 3 compounds, esreboxetine for fibromyalgia & PD 332,334 for generalized anxiety disorder (GAD), due to “current market dynamics” and due to the consideration of it being “unlikely that either compound would provide meaningful benefit to patients beyond the current standard of care.” Although neither drug was abandoned due to safety reasons of patients this is yet another setback in the R&D department for Pfizer. Discontinuing compounds this late in Phase 3 is not as common as earlier withdrawals, but likely competitive and cost factors led to the decision to scrap their further development.

Other achievements include:

Global Approvals of Fesoterodine (US), Maraviroc (Japan), Macugen (Japan), Rifabutin (Japan), Sutent (Japan), Champix (Japan), Genotropin (Japan), Zithromax SR Peds (US), Sutent (Japan) and Revatio (Japan).

Global Submissions of Fablyn (Europe), Lyrica (Japan), Xalacom (Japan), Maraviroc (Japan), Maraviroc (US), Lyrica (Europe), Revatio (US and Europe), Geodon (US), Geodon Peds (US and Europe), Norvasc (Japan), Lyrica (Europe) and Zithromax SR (Japan).

The Numbers:

In the spreadsheets provided I’ve listed the past five years of data. (Data dating to 1991 available with purchase of full analysis or to SAML subscribers).

Whenever I look through the operating numbers of a company I’m looking to evaluate three main items:

• A consistent theme of performance
• Conservative fiscal management
• Emerging trends that hold the potential to influence the company either positively or negatively in the future

One important habit for an investor to get into is not to focus too exclusively on historical data. While I use historical data to reveal important trends, fundamentals and a fair market valuation of a company I constantly remain conscious of current operations, the strategic focus of management and how a number of other factors will contribute to its future success.

When you examine the historical numbers of Pfizer there’s not a lot that makes an investor enthusiastic about its future prospects. The dividend grew at a substantial rate for over 40 years but has now been cut in half and growth in profitability has stalled dramatically. The future loss of revenue from Lipitor will dramatically affect the business and despite commitment to new drug development the company has performed poorly on executing and achieving strong results with its R&D spending.

Revenue growth has outpaced expense growth over the past five years and that is positive, but revenue growth over the past five years has been anemic at 1.8%. The company has established an impressive history of return on equity (ROE), but their return on investment (ROI) related to research and development costs have been abysmal bringing into question management’s ability to achieve results in this key department. Despite lowering SGAE (as % of net sales) from a historical average of 37% to ~32% the bottom line hasn’t adjusted sufficiently indicating other fixed costs are dragging down profitability and heavy job cuts are only a short-term solution.

Book value growth per share (BVPS) has averaged only 3.3% over the past five years versus a historical average around 8%. In real terms (after inflation) management has likely returned zero book value growth which is not something that I regard as positive as a value investor.

Pfizer relies on its pharmaceutical division for over 90% of revenues. Their animal health division has continuously generated 4-6% of revenues which amounts to a questionable benefit to the company’s operations and with no growth in revenue this division should be a candidate for a non-core asset sale.

Pfizer had an excellent history of dividend growth with a historical average of over 18% per year before cutting it by 50% in 2009 to $0.64 per share on an annual basis. This likely won’t be forgotten by investors seeking a stable yielding investment and future dividend growth will be tempered at 5-6% annually as the company looks to tackle new debts taken on through the Wyeth acquisition.

At some point the company must tackle the massive amount of goodwill sitting on their balance sheet that stands at 21% of their market capitalization at the end of 2008. Compare that to Coca-Cola (KO), owner of the most valuable brand globally, with goodwill of 4% of market capitalization and the premium offered to Wyeth shareholders in order to purchase the company will only further compound this serious obstacle for Pfizer.

DCF Valuation/Target Price:

(Available with full version)

This segment contains access to a dedicated online discount cashflow calculator (DCF), historical numeric summary, current financial data and DCF valuation with target price.

“You’re Pfizered!”

(Available with full version)

This segment contains a discussion of Pfizer’s recent purchase of Wyeth (WYE) including identified synergies and conflicts, an update on Pfizer’s current restructuring, a discussion of influences to corporate culture and future investing prospects of the two combined companies.

Disclosure: I own shares of Coca-Cola (KO), Russel Metals (RUS), Manulife Financial (MFC), Johnson & Johnson (JNJ) and structured senior debt of General Electric (GE) at the time of this post.

Read more about The Stock Analysis Mailing List

(SAML) including format, pricing, delivery method and disclaimer.

Purchase your individual copy of Taking Stock in Pfizer (PFE)
Each 22 page PDF includes:
- A ‘Critical’ Analysis
- Company Description
- Clinical Trial Description/Outline
- Extensive Situational Analysis
- Management Analysis
- Critical Competitive Analysis
- Restructuring Analysis
- Examination of Operating Results
- DCF Valuation with Target Price
- “You’re Pfizered!”
- 18 years of Organized Financial Data (excel document)

Visit the TMWTFS Stock Analysis & Reviews page for a full list of stocks I have covered and comments written by my peers.

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Sysco Corporation, through its subsidiaries, markets and distributes a range of food and related products primarily for food service industry. It distributes frozen foods, non-food items, restaurant equipment and cleaning supplies. It serves restaurants, hospitals and nursing homes, schools and colleges, and hotels and motels.

Trend Analysis

This section measures the trends for past 10 years of corporation’s revenue and profitability. The parameters should show consistent growth trends. The worksheet is at SYY stock analysis.

• Revenue: Increasing trend in revenue with average growth of 9.4% (3.4% standard deviation). Immediate past five years show reducing trend of growth rates from low teens to high single digits. This is sign of slow down in growth rates.
• Cash Flow and Income from operations: The operating income trend is relatively increasing with average growth rate of 12.6% (9.4%). The company did face some challenges in 2004 to 2006 time period.
• EPS from continuing operation: In general, the EPS also has an increasing tread (with a blip in 2006) with average growth rate as 14.7% (10.2%).
• Dividend per share: Dividends per share are consistently growing for the last 10 years.

Risk Parameter Calculation

Here I use the corporation’s financial health to assign a risk number for measuring risk-to-dividends. I have discussed this in more detail at Dividend Tree. This is calculated as arithmetic average based on price, yield, EPS growth rate, payout factor, gross margin, operating margin, and financial leverage. The risk number for risk-to-dividends is 1.86. This is a medium risk category as per my 3-point risk scale. An increasing payout factor and historically high yield is making SYY dividend as a medium risk.

Quality of Dividends

This section measures the dividend growth rate, duration of growth, consistency over a period of past ten years.

• Dividend growth rate: The average dividend growth (18.9%) is higher than average EPS (14.7%) growth rate. In general, the corporation’s EPS is also consistent when compared to dividends per share. This is a good aspect.
• Duration of dividend growth: Dividends have continuously grown for the last 38 years.
• 4 year rolling dividend growth rate for past ten years: It is more than 10% on 4 year rolling basis. This is a good aspect.
• Payout factor: Historically. it has been less than 50%. However, the trend is showing that payout factor has been increasing from low 30s to now close to 50s.
• Dividend cash flow vs. income from MMA: Here, I analyze how the dividend cash flow stacks up against the income from FDIC insured money market account. The baseline assumption is (a) stock is yielding 4.4%; and (b) MMA yield is 3.4%. Considering historical average growth rate of 18.9%, the stocks dividend cash flow at the end of 10 years is 4.55 times MMA income. If we assume my average expected growth rate of 9.4%, then the dividend cash flow is 2.15 times MMA income.

Fair Value Calculation

This section determines what price I should pay to buy a given stock

• Net present value (NPV) price based on 20 year DCF: $18.21
• Average high yield price calculated based on past 10 years: $40.1
• Pricing based on past 10 year relative price-to-earnings ratio. $41.5
• Pricing based on price-to-earnings ratio of 12: $19.0
• Graham number: $15.10

The range of fair value is calculated as $20.3 to $26.7. This determined by taking average (for high value) of above five parameters and then subtracting it with half the standard deviation (for low value).

Qualitative Analysis

The strength of SYY is its well established distribution network and existing leadership position. Putting this in context of economic environment, it has opportunity to grow due to its pricing ability and leveraging existing distribution network. In addition, the commodity prices have also cooled down. At the same time, the revenues are likely to be under pressure. It’s largest customer base is restaurant industry which is expected to have a slow down.

• This quantitative analysis shows that, so far, SYY has been able to maintain its historically consistent profitability. The revenues and operating incomes are under pressure and expected to continue for next few years. It appears that in last few years, the dividend growth is coming from the combination of payout factor and growth in EPS.
• In next 3 to 5 years, the flexibility in payout factor, stable profitability, and slow EPS growth provides room for maintaining the consistency is dividend.
• Assuming that the corporation’s existing trends in profitability and growth continue ‘as is’, I expect dividend growth to slow down relative to its historical growth. Therefore, with next 8 to 10 year horizon, my average expected dividend growth will be 9.4% with standard deviation of 3.4% (this is equal to the average growth in revenue).

Conclusion

The company raised its annual dividend for 2009 from $0.88 to $0.96 per share. The stocks risk-to-dividend number is 1.86 (medium risk category). In addition, the dividend cash flow is also 2.15 times the MMA income based my expected dividend growth of 9.4%. I will continue to hold my existing position. The existing price within my fair value range. I will add to my position, as long as my allocation allows.

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If you would like one of your articles posted here at Old School Value, contact me with a link of the post and if selected, it will be displayed in the “Featured” section for greater exposure.

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