If you’re going to be a stock picker then one of your goals has to be to beat the market. It must be, otherwise why would you bother with all the extra work? And if you’re out to beat the market then it makes sense to check each potential investment against the market to see which is best.
The FTSE 100 is a great investment
Just to recap, the FTSE 100 (via an ETF or index fund) is a pretty fantastic investment to start with since it always pays a dividend, the earnings almost always trend upwards over the longer term and it’s virtually certain to be around when you retire so the risk of losing all your money is almost zero. Many studies have shown that for UK investments it’s almost impossible to beat over the long term.
Why pick AstraZeneca?
AstraZeneca has been scoring very well on my screens for a while so it was due a review and I’m also looking to buy something as well. It’s a very large, globally diverse company and it’s in the FTSE 100 anyway, so it’s not like we’re comparing the FTSE 100 with some crazy micro-cap start up. It’s a big, stable company with tens of thousands of employees earning billions in revenue and profit.
The gap between the FTSE 100 and AstraZeneca is about as small a gap as you’re likely to get between an index and a single company so the comparison is fair I think.
Checking past performance
Both have more than 10 years of positive earnings with no losses and no periods without a dividend, so both have good stable histories.
Over that last decade the FTSE 100 has grown earnings at about 7% while AstraZeneca has managed about 12%. Dividends have increased for both at sustainable levels with the dividends covered more than 2 times in each case.
The FTSE 100 has managed to return almost 10% on retained earnings while AstraZeneca has managed over 20%. Retained earnings are that bit of the earnings that management has kept back (they are your earnings since you are the shareholder and owner) and invested them within the company. Since it’s your money you should want it re-invested at the highest rate possible.
In summary, AstraZeneca has had better earnings growth than the FTSE 100 and has produced better rates of return on each pound of shareholder money retained within the company. AstraZeneca wins round 1. Now let’s look at the present.
What return are you getting from day one?
At 5990 (8th July 2011), the FTSE 100 has an earnings yield (inverse of the PE) of 8.8% and a dividend yield of 3.1%. At 3127 (8th July 2011) AstraZeneca has an earnings yield of 11.3% and a dividend yield of 5.3%, higher in both cases.
Yields are the simple bit in investing that most people understand without much effort since they’re used to looking at yields on savings accounts. The higher the yield the more ‘interest’ you’re getting on your money, especially in the case of dividends since the analogy with interest is all the closer as they are both cash payouts.
With the bigger yields, AstraZeneca wins round 2.
Which has the brighter future?
Ahh the future; land of hopes and dreams or a vast black impenetrable fog, take your pick. To be honest I prefer hopes and dreams but before we get too far into future gazing it’s important to remember that the future will always be highly uncertain. The only thing that changes is how much people are aware of that uncertainty.
Given that the future plays its cards close to its chest, one handy trick to increasing your predictive powers is to predict something predictable. If I say that the Sun will come up tomorrow then I’m almost certain to be right. I could even say that the Sun will come up 200 years from now and I’d still probably be right.
The same sort of idea can be applied to investing. If you take a company with volatile earnings, perhaps some years of loss, it becomes difficult to say anything meaningful about what that company’s future earnings might look like, other than saying they might look like the past, i.e. volatile and therefore unpredictable (or at least less predictable). In fact there might not be any future earnings if they have too many of those loss making years.
On the other hand, a company with a long history of relatively stable earnings growth, no losses and no dividend cuts or cancellations may just have a future that also looks like its past, i.e. relatively stable, predictable growth that can be extrapolated into the future with some small degree of confidence.
Both AstraZeneca and the FTSE 100 have relatively predictable earnings and dividend growth and that’s how we can make an educated guess at what their futures might look like.
To infinity and beyond
Using the rates of return on retained earnings and amount of earnings typically retained, the future growth of earnings can be estimated as about 6% for the FTSE 100 and 12% for AstraZeneca.
By combining estimated future earnings and the average PE of the last few years (14 for the FTSE 100 and 13 for AstraZeneca) and adding in the total amount of dividends paid out, the total return to shareholders over the next 5 years can be estimated as:
56% for the FTSE 100
212% for AstraZeneca
No prizes for guessing which one looks more attractive.
But hold on! Don’t expect those estimates to be accurate, certainly not to a single percentage point. But they may well be a reasonable guide as to what will happen… and so, kapow! AstraZeneca wins round 3.
Pesky Mr Market
There are problems with these sorts of projections. The first problem is they are almost certainly wrong. There’s no way that a buyer of AstraZeneca today will see a 212% return in 5 years. Even if the projections of future earnings are spot on (that’s problem number 2, they won’t be) Mr Market frequently values companies anywhere between half and double (and sometimes much more) what they should be worth.
Even if I am so clever that my earnings projections are right, Mr Market may value the company at half what I expect him to, and so my total returns would be 28% for the FTSE 100 and 106% for AstraZeneca. Or, if Mr Market is very happy in 5 years time then the return might just be 112% for the FTSE 100 and 414% for AstraZeneca.
Unless you can live with this level of uncertainty (which in the world of equities is actually quite small) then you might be better off with an index tracking stock/bond portfolio and get used to the 6-8% annual returns.
However, the main point still stands in that since we cannot know what Mr Market will do in the future, we have to effectively ignore him! That in turn means we look back to the original, very probably wrong, projections, which means that…
If you think you have the stomach for stock market investing and can handle large amounts of uncertainty (the antidote to which is good old blind faith… no seriously, it is), then AstraZeneca in this case should appear to be the better investment.
Since I eat my own cooking I have personally invested in AstraZeneca as well as adding it to the UK Value Investor model portfolio, the UKVI 20 (better name suggestions on a postcard to firstname.lastname@example.org please). The expected holding period is the usual 5 years.
New series and new look website
I’ll be starting a new series of posts soon covering all the details of how I invest and what tools I use to find good companies at good prices, so if you don’t want to miss any of that and you’re not yet a subscriber (hundreds of intelligent investors can’t be wrong!) then please subscribe via RSS, email or Twitter.
If you have anything in particular you’d like me to post about then let me know via email@example.com a comment on the web site and I’ll do my best to fit it in.
I'm not sure this kind of analysis is particularly actionable. AstraZeneca and the pharma sector in general is priced so attractively because the market has significant concerns over the aggresive patent cliff, the future returns on pharma research, and regulatory pricing pressures. Astrazeneca is among the cheapest because it faces a very steep patent cliff. Tim Anderson thinks AZN will face the biggest revenue decline among big pharma over the coming decade (http://blogs.forbes.com/matthewherper/2011/06/30/the-best-drug-companies-of-2020/)
I own AZN and think these fears are overblown. But I think it would be a mistake to buy in without explicitly making a bet on the prospects of the pharma sector and just going off past yields and growth rates.
Hi Anon. I don't think it's always a mistake to ignore the fine details as there are plenty of research papers which point to various methods of stock selection which outperform and take virtually no notice of factors such as patent cliffs.
However, in this case I did look at the patent cliff but couldn't come to any meaningful conclusions. I didn't include it in the post as I wanted to focus on the quantitative factors involved in the kind of valuations I like to do.
Qualitative factors may be important too, which is why I want to cover them in an upcoming series of more detailed posts about this sort of analysis. However, I only give qualitative factors a 20% weighting at best since I am mostly interested in the numbers.
I appreciate that the projections may be totally wrong, which I hope to have conveyed in the post. Apologies if I wasn't clear enough about that.
And thanks for the link to Tim's article.
Mark Carter says
Here's one idea I've been looking at …
AZN has a dividend cover of 2.57, so it retains 61% of its earnings (1 – 1/2.57). AZN has a ROE of 42%, so on reinvested earnings that's 25% (42% x 61%), and you get a a divvie over 5%. That's a combined return of 30%. Additionally and importantly, it has low debt and low PER ratio of under 8.
Now, we're not going to get that 30% return, that's far too optimistic, but i think that at least things are tilted in our favour.
Morningstar has an interesting analysis: http://bit.ly/pya4T0
I should also point out that AZN is increasing its presence in China, where branded drugs are saleable even if they are off-patent.
Thanks for the reply. You're right in that a diversified basket of value stocks will tend to outperform. Greenblatt's value weighted index seems like a pretty excellent idea. Clearly this is a less time-intensive approach, so I guess by spending more time on prognostication I must somehow hope to outperform even further. AZN is more than 5% of my portfolio as a result.
Also, just so readers know, the FDA decision on approving AstraZeneca's biggest pipeline drug is in 5 days. I think most people are expecting a positive result, but the more risk averse might want to wait before investing.
Finally, I might suggest you look at RIMM, even if you don't actually hold US stocks. The numbers are amazing. I haven't bought in because I can't overcome my bias about how ridiculous blackberries are.
But aren't you are comparing returns with 0% diversification compared with 100% diversification?
I'm not saying that AZN is not a good pick (I have bought it recently – for income) but if you were suggesting buying it *only* you would be taking on a pretty big risk (cf. BP)
However, if your criterion is only to buy stocks that exceed the FTSE average (in whatever) – then that is pretty sensible… but with diversification.
John Kingham says
@Mark – That Morningstar analysis was one of the ones I looked at which took the counter position to other analysts fearing the patent cliff. That's why I had no clear conclusion on that issue. As for ROE and retained earnings, that's partly how I project earnings (the other part is using ROE based on increases on earnings divided by retained earnings over a period).
@Moneyman – I'm talking about a diversified portfolio, so yes the criteria is to buy better companies with better yields compared to The Market, on the assumption that as a group they will outperform as long as you gently churn the portfolio toward 'better', if you see what I mean.