AMM Dividend Letter Issue 28: How to Beat a Pigeon at Investing with Pfizer (PFE)
This is from the AMM Dividend Letter released April 7, 2016. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
This is the competition. It’s you versus a pigeon. Both you and the pigeon have two lights in front of you, one red and one green. You have to guess which light, red or green, will flash next. Do you think you can beat the pigeon at this game?
You’re probably thinking, “Of course, I have this big beautiful brain that has put mankind on the moon. I can do better than a bird with a brain a fraction of the size of mine. Don’t we call dumb people ‘bird brains’ for a reason?”
What if I told you the flashing lights will be completely random. Do you still think you could beat the Pigeon?
Don’t worry this game has already been done as an experiment. In the experiment, people were measured against both rats and pigeons. Each subject received a reward after guessing correctly which light flashed next. The flashing lights were completely random but the green light flashed over 80% of the time. The optimal strategy is guessing green every time. You’ll be right 80% of the time.
The rats and pigeons figured out this strategy fairly quickly. The human subjects figured it out quickly too. So it was a tie, right? Wrong.
After a little bit of trial and error, the rats and pigeons guessed green every time and scored an 80% success rate. The people on average scored a 69% accuracy. Why? Because of that big beautiful brain of yours.
Humans are the smartest species and we know it. Because we are so smart, we are overconfident in our ability to predict future events. Maybe the green light flashed several times in a row and the human subjects just “knew” that the red light would flash next. Even though they were told that the flashes would be completely random. On average the human subjects guessed red 1 out of 5 times and this dropped their accuracy to 69%.
The pigeon and the rat do not suffer the same illusions. They just know that if they guess green every time they have a very good chance of getting a reward.
We can’t help ourselves. As humans, we look for patterns and causal relationships in everything. A section in the left hemisphere of our brain drives this. It leads us to believe with just the right amount of data we can figure out the pattern and predict what is going to happen next.
Our desire to find patterns combined with our overconfidence gets us into trouble with complex data like investing.
Investors, professional and amateur, spend a lot of time looking at charts trying to figure out the next wiggle of the stock market. They then trade in and out of the market based on what they think will happen next . What usually happens is they are wrong and they’ve guaranteed themselves a loss of money through excessive trading fees.
Take the beginning of this year, 2016, for example. The stock market had its worse start since at least 1897.
Based on past charts and historical patterns it was all but a certainty that the stock market would continue to go down. Nothing was more extreme than the Royal Bank of Scotland’s announcement to “sell everything” and that “2016 will be a cataclysmic year”.
What happened if you listened to RBS on January 12, 2016 and sold everything?
The S&P 500 is up over 6%. Even after the worse start to any year since 1897 the S&P 500 is flat for 2016. To be fair, we’re only a few months into 2016.
By trying to guess when the stock market will decline next, what RBS and others are doing is guessing when the red light will flash next. We know the red light will eventually flash. We know the stock market will eventually go down but we do not know when. The day-to-day, month-to-month, even year-to-year price fluctuations of the equity market are random. The stock market is a dynamic system with hundreds of interacting variables and overlapping feedback loops. Guessing future moves with near certainty is impossible.
Here’s the good news. Just like in the flashing light experiment above we don’t need to guess the short-term moves of the stock market. We have data on the equity markets that is equivalent to the green light flashing 80% of the time.
The following table is from A Wealth of Common Sense. It shows the percentage chance of having a positive total return given a specific time period.
The longer we stay invested the better our odds of having positive total returns. According to Ben Carlson, The worst 20 year period for total returns was 54% and the worst 30 year period was 854%.
The objective of investing is the same as the simple light flashing experiment, to maximize our rewards. Trying to guess what equity markets will do tomorrow, next week, or next month and then trading in and out of the stock market to try and catch these moves will only harm our portfolios and ruin our potential to maximize our long-term investing rewards.
We need to focus on what we can control. Finding quality companies and paying a fair price for them.
Dividend Stock in Focus
Pfizer, Inc. (PFE): $32.76*
*price as of the close April 7, 2016
Pfizer is the world’s largest pharmaceutical company based on global sales. But everyone knows it for that little blue pill. You know the one that seems to have a lot of TV ads during golf tournaments for some reason.
We first bought Pfizer in our dividend growth portfolio in September of 2011 because we thought they were extremely cheap and because Pfizer is a dividend stalwart, a company that raises its dividend year-in and year-out.
We’ve continued to add to Pfizer because its intrinsic value has increased over the years and because CEO Ian Read is on a path of restructuring. Mr. Read is streamlining operations by spinning off non-core divisions like Zoetis (ZTS) and acquiring acquisitions for its core businesses like generic drug maker Hospira.
Mr. Read might potentially split Pfizer up even further in order to pursue his ultimate goal of lowering Pfizer’s tax bill by moving out of the U.S.
Following its purchase of Wyeth, Inc. for $68 billion in 2009, Pfizer cut its dividend so that it could quickly repay the debt issued for the buyout. After cutting its dividend down to a quarterly rate of $0.16 per share, Pfizer now pays $0.30 per share on a quarterly basis. Since February 2009, Pfizer has grown its dividend at a compound annual rate of 9.5%.
Catalysts for Dividend Growth and Price Appreciation:
Pfizer and Allergan agreed to a $160 billion merger. The deal was structured as a tax inversion. By merging with Allergan, Pfizer would move its country of domicile from the U.S. to Ireland. Ireland’s corporate tax rate is 12.5% versus the 35% U.S. corporate tax rate. The U.S. also taxes U.S. corporations on any profit made overseas that is brought back, “repatriated”, to the U.S. If Pfizer redomiciles in Ireland through a merger with Allergan, Pfizer can reinvest those profits back into its U.S. operations without incurring a tax because it is no longer a U.S. company. Pfizer currently has over $50 billion in cash overseas.
The tax savings alone make a deal like this very attractive but the combined potential of the two companies was even more attractive.
Unfortunately, the deal is no more.
As we were writing this, the Treasury Department released a set of new aggressive anti-tax inversion laws. The new laws specifically target the Pfizer and Allergan merger and because of the new laws Pfizer and Allergan have scrapped the merger.
Pfizer’s CEO Ian Read is set on moving Pfizer out of the U.S. to bring the company’s costs in line with its non-U.S. based competitors. While it won’t be through a merger with Allergan, Mr. Read will likely find a way to redomicile Pfizer out of the U.S. It may take splitting Pfizer up into 3 separate businesses to do so.
Before the Allergan deal was announced, Pfizer told shareholders that at the end of 2016 management would announce whether it was going to split the company up through a series of spin-offs. Expectations for at least one spin-off grew when Pfizer bought Hospira in a bid to boost the value of Pfizer’s generic and biosimilar business. Then the Allergan deal took priority and Pfizer’s management postponed the split up decision until the end of 2018.
Now that the Allergan deal has been canceled. Pfizer is free to continue its spin-off plans unless another merger candidate appears.
The SEC requires 3 years of financial reports broken out by division before a business unit can be spun-off. Pfizer started reporting on its 3 business divisions in 2014. The minimum expectation is for Pfizer to separate its Established Business (generic drugs and drugs soon to be off patent) from its Innovative drug business (recently approved drugs and drugs still in development).
A brief sum of the parts analysis for Pfizer’s three business divisions using Earnings Before Interest and Taxes (EBIT) values Pfizer at $43 per share.
Click image to enlarge.
Promising Pipeline & Ibrance
Over the last few years, Pfizer’s revenue has declined due in part to a couple of key drugs losing patent protection. Pfizer lost the patent on Lipitor, on of the most commercially successful drugs ever, in late 2011. The company has been working hard to come up with new drugs to replace the lost revenue. That effort is starting to pay off with some 90 potential new drugs in the pipeline. One of Pfizer’s most promising new drugs is Ibrance.
Ibrance is a specific breast cancer treatment and it is in stage 3/registration phase with the FDA. Estimates of peak sales are $10-15 Billion with Ibrance potentially reaching $4 billion in annual sales by 2020. Ibrance targets metastatic breast cancer and in combination with AstraZeneca’s Faslodex (an estrogen blocker) patients survived on average 9.2 months before their cancer worsened. The control group survived 3.8 months.
Pfizer is working on more indications for Ibrance which could push annual sales well past the estimated $4-5 billion annual sales.
Pfizer could get bigger through a buyout or merger first, before they pursue spinoffs. They have the balance sheet to buy another biotech company in an effort to increase their roster of promising new drugs. Shares in biotech companies are still trading well below their peak last year and the cheaper prices may entice Pfizer to pursue one more buyout before separating the company.
Pre-Mortem (Potential Risks to our Thesis):
More Anti-Inversion Laws
As we were writing this the Treasury Department released a set of new aggressive laws aimed to stop Tax Inversion deals. The wording of the new laws suggests that the authors were targeting the Pfizer and Allergan deal. There are some big questions with these new laws including why is the Treasury Department, part of the Executive Branch, and not Congress writing these new laws? And why are the laws being changed and applied on an ex-post facto basis? The new laws also seem to change the meaning of what constitutes a share, or ownership in a company.
Pfizer is looking for a way to move out of the U.S. The company has now had two deals scuttled because of changing tax laws. Staying in the U.S. does not mean Pfizer will go out of business, however, it does mean Pfizer will have less capital to reinvest into its business versus its foreign-based peers. For an industry built on R&D, every bit of capital reinvestment helps. Over time as Pfizer’s foreign peers reinvest more into their businesses they will slowly out compete Pfizer.
Pfizer’s pipeline of new drugs, especially its breast cancer drug, is very attractive. However, we don’t know with certainty what the future will bring. Pfizer’s potential blockbusters may not be blockbusters and the revenue Pfizer has lost from Lipitor may not be regained. For sustained dividend growth, we need business growth.
With the Allergan deal no longer an option, our base case estimate of fair value for Pfizer using a discounted cash flow model is $40 per share. A sum of the parts estimate of Pfizer’s fair value is around $43 per share. If Pfizer’s pipeline, especially Ibrance, turns out to be as successful as currently estimated then Pfizer is worth more.
Pfizer’s share price had been under pressure as arbitrage funds sold Pfizer shares short and went long allergan shares in anticipation of the deal closing. Now that the deal is off Pfizer’s share price has popped as the arbitrage funds unwind their positions. Pfizer may give back some of its gains from the last few days as the buying pressure subsides, but in the long run we expect the company to offer favorable returns from current levels.
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