Profit from what you don’t know
Sticking only with stocks you know can lead to mediocre returns, claims this analyst. Why not look for something completely different?
Noted fund manager and author Peter Lynch famously coined the phrase “Invest in what you know.”
And made a lot of money sticking to his words.
But now here’s an opposite suggestion. Invest in what you don’t know.
There is a good reason to do this, says Mr. Randy McDuff. If we only invest in what is familiar to us, we may get complacent. We may miss out on some real sizzle in our portfolios.
And Mr. McDuff does appear to know what he’s talking about. Retiring early from the brokerage business in Winnipeg, he runs several successful portfolios on Marketocracy.com. In fact, he has two of the top 10 portfolios among the 50,000 on the site.
So he shakes up our investment certainties as he tells readers of Investor's Digest of Canada why it’s time to fly from the familiar.
And then he gets specific. It’s better to invest in European drug stocks than the famous U.S. names we know so well.
The comfort zone
“Investing in familiar names, by default, implies we are overweight in local, domestic companies,” says Mr. McDuff. “This creates the possibility of a false confidence. In order to stay within our comfort zone, a very real risk exists that we wind up owning ordinary or less-than-ordinary companies.”
The analyst has thrown down the gauntlet. Get out of the rut. But he’s going to go even further.
“Perhaps it’s time to put the notion of investing in what we know aside,” he states bluntly. “False confidence is no substitute for fundamental investment research and thorough peer analysis.”
And there’s one area, he says, where “Invest in What You Know” has been a total failure. Large U.S. pharmaceutical firms.
For Canadian investors, of course, the U.S. drug companies offer variety — a series of investments not readily available on this side of the border. But it’s the wrong variety, says this analyst.
A decade of disappointment
“Long-term investors piled in a generation ago,” Mr. McDuff says of the U.S. drug giants. “The lure was pie charts full of favorable demographic trends on drug use. After all, companies produce a pill for every real or imagined need. And as we age, don’t we all consume more drugs? The business model was touted as being recession proof.”
That has led to a decade of disappointment, he adds. How would investors have done if they held the three biggest U.S. companies — Johnson & Johnson (NYSE-JNJ), Pfizer (NYSE-PFE) and Merck (NYSE-MRK)?
If you had purchased Johnson & Johnson in September 2001, it would have just broken even now, before dividends. The same holds true if you had purchased Pfizer 12 years ago. But if you had purchased Merck 14 years ago, you would still be waiting for it to break even.
Not exactly the ideal “buy for the long term” scenario.
And while bullish analysts continue to promote these stocks, “they fail to explain why these so-called recession proof U.S. companies are now forecasting revenue and profit declines,” says this skeptical analyst.
Nor do they explain why these firms are doing so poorly when many European and Asian pharmaceutical firms are “quietly reporting record sales and earnings.”
Financially stronger
Merck and Pfizer are both entering into mergers. But this analyst fails to see how turning four companies into two and adding big heaps of debt to their respective balance sheets will do anything more than add capital risk for shareholders.
The market is getting suspicious, too. Valuations for the top seven U.S. drug companies are at their lowest level in a decade.
But this is not true around the globe. Three of the top seven global firms, based upon enterprise value (the theoretical takeover price of a company) are in Europe.
They are Roche (Zurich-ROG), Sanofi-Aventis (NYSE-SNY) and Novartis (NYSE-NVS).
All three reported record 2008 fiscal results. All three raised their 2009 dividend payouts. All three have new drug approvals in line to compensate for expiring patents through 2012.
And all three are financially stronger than their U.S. counterparts. They have better capital ratios and less debt. Like the American firms, they grow by acquisition. But the Europeans pay with cash, not stock, a decided benefit to their shareholders.
Not least, they are geographically closer to important emerging markets in Eastern Europe and Asia.
North American bias
If he were to pick one of these three, Mr. McDuff leans to Sanofi-Aventis. It is the leading producer of vaccines in the world, with 21 per cent of the global market. It is now working on a vaccine for Dengue fever, which could ultimately post worldwide sales of over US$1 billion. It also plays a major role in diabetes treatment.
Sanofi is less expensive than its peers, trading at just 6.8 times enterprise value, well below the industry average of 8.9.
This low valuation might be due to a lack of coverage on Wall Street. Only four analysts cover Sanofi. In the meantime, of the almost 50 analysts covering the three big American firms, not one dares to publish a “sell” despite the prospect of falling revenues.
North American bias? Mr. McDuff certainly thinks so. This stock ultimately deserves a premium valuation, in his opinion. He recommends Sanofi-Aventis to his Investor's Digest of Canada readers as “a core holding in a globally-themed large-cap portfolio.”
Well there’s the challenge. Stick with what you know and you may end up with unremarkable returns, this investor suggests. Venture into new territory and you may find that what you don’t know can help you.
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