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I've pasted the report from October 1st below. In it is described the thought process that narrowed the field from 4 to 2.


by Jeff Fischer (TMF Jeff)

ALEXANDRIA, VA (Oct. 1, 1997) -- Pharmaceutical companies are not cheap right now. In fact -- you've probably noticed -- not many leading companies in any industry are currently selling "on the cheap." The S&P 500 trades at 20 times earnings estimates and is growing earnings 17% annually, while leading stocks are trading at premiums above that of the S&P.

We would have said the same thing ten years ago, too -- in fact, we would have said it with a much greater degree of conviction. Stocks were much more "ahead of themselves" in 1987 than they might be right now, when measured by underlying earnings growth. Still, the right companies have handily beat the market since 1987 -- even if you bought them just prior to the 25% market crash.

All of our healthcare considerations are trading at "premium" prices that are at the high-end of their historical range. If we were buying any of them outright and in bulk right now, for any time period less than five years, it would be a questionable purchase based on the rate of return that we could realistically anticipate. However, we'll be buying our stock steadily over long periods of time, so we're not quite as concerned with the current valuation. That's why we first looked at the business behind each company rather than the stock valuation. It's the business that we want to buy for the coming decades, and it appears that, to start, we'll have to "pay up" for that business -- whichever business we decide upon.

For DRP investors, the world can't stop when stocks look "expensive." If so, the world would have stopped in 1995. Big mistake. We're buying these companies hoping for declining stock prices over the coming years as we build a position -- though declines shouldn't be necessary in order to reach our goals. We do hope that Intel goes down, though. We hope that all of our stocks go down once we begin to buy them. Our eyes are set on the twenty-year horizon, not on this year, not on five years from now. Randy would argue that all of these stocks are overvalued. Nobody is saying otherwise. They are pricey. Buying something with the knowledge of what you're doing is much different than buying something naively, though.

DRP investing systematically has you invest money over long periods of time while dollar cost averaging. With this strategy I arguably want to begin buying leading companies now, rather than search out companies that have lagged in this market for some reason and then hope that they're granted higher stock prices (along with greater business success) down the road. A mix of both types of investments is what we're aiming for.

That "filibuster" said, let's look at some numbers for our healthcare companies.

Schering-Plough = SGP
Abbott Laboratories = ABT
Pfizer = PFE
Johnson & Johnson = JNJ

Trailing sales Market cap Price/sales

SGP ($52) $6.0 billion $38 billion 6.3
ABT ($64) $11.5 b $49 b 4.2
PFE ($60) $11.9 b $78 b 6.5
JNJ ($58) $22.3 b $77 b 3.4

5-year est.
growth rate P/E P/E on '98 est.

SGP 14% 29 23
ABT 13% 25 21
PFE 15% 38 30
JNJ 15% 24 20

Operating Return on
Margin Net Margin Equity/Change

SGP 29% 21% 52% (up)
ABT 23% 17% 40% (up)
PFE 27% 17% 29% (up)
JNJ 20% 14% 27% (down)

Expected R&D Cash and Long-term
as % of sales equivalents (8/97) debt

SGP 12.5% $699 million $64 m
ABT 11.0% $146 m $931 m
PFE 16.6% $2,200 m $723 m
JNJ 9.9% $2,300 m $1,260 m

Prior Year Prior Year
Sales Growth Earnings Growth

SGP 11% 16%
ABT 10% 13.7%
PFE 13% 20%
JNJ 14.7% 16.7%

Main Business

SGP -- Pharmaceutical is 90% of sales,
allergy, respiratory are main
drugs, CLARITIN is 20% of sales

ABT -- Four divisions contribute about
equally to sales (pharm., nutritional,
hospital, diagnostics)

PFE -- Pharmaceutical is 72% of sales,
cardiovascular main; leading animal
health care company

JNJ -- Pharmaceutical is 33% of sales,
professional 37%, consumer 30%

The most important numbers may be the research and development figures. Pfizer has more products in the pipeline than our other considerations, and perhaps rivals even Johnson & Johnson in what it has in the works volume-wise in its pharmaceutical division. That shouldn't be too surprising when you consider that last year Pfizer sold more pharmaceuticals than did Johnson & Johnson, at $8.1 billion compared to $7.3 billion.

I'm favoring Pfizer due to its current deep product portfolio that contains over half a dozen newer, niche-leading products that account for a bulk of sales, as well as its pipeline of well over a dozen new drugs in late stage development. The company hopes to have 17 new drugs on the market in the year 2000, and its specialty (cardiovascular) is an increasingly important market as the population ages. Pfizer may be most likely to improve margins and return on equity, too, due partly to the higher margins earned on new products and the lack of competition during the patent protection period. Even while currently spending the most on research and development, the company has the second-best margins of the group.

Unfortunately, Pfizer's multiples to sales and earnings have plenty of room to contract, as the stock is the most expensive of the four, primarily due to the potential just cited. The market apparently agrees that of these four companies, Pfizer has the most potential for growth. The premium on the stock rivals that of Coca-Cola, as Pfizer trades at 30 times 1998 estimates -- twice its expected long-term growth rate of 15%. The company did grow earnings per share 20% last year, though, and it appears that the 15% growth expected by analysts is a little less than what the market anticipates -- or is hoping for.

Johnson & Johnson is my second choice. On valuation, I like Johnson & Johnson better. I like its diversity and world-leading status. But on business growth potential and the ability to surprise to the upside, I favor Pfizer. I can't say that I'd be afraid to buy any of these four stocks with a twenty-year time horizon, though. They may not all beat the market over that time, but they are all excellent companies -- as their price premiums in part indicate. And who knows... Schering-Plough or Abbott may be the best two investments of the group over the next two decades. I've developed a bias towards the other two, but I'm just a human. And sometimes I'm a moron, too, some say. But Pfizer is my first choice, and J&J second.

As this is a public portfolio, I'd like to hear which company you favor for the Drip Portfolio and why. Please send me your email and we'll continue from there.

Fool on...

Portfolio Information

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