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Investments Inc.

spacer January 2001

With the severe revaluation of the glamour stocks over the past year, it is fun to watch where the money is bound. The watchword of the day is “defensive” — that is, to stick with blue chip companies in sectors that are not considered to be as vulnerable to a cooling economy. Sector rotation is a normal part of the market cycle, but what we are getting now is more like “optimism migration.”

One current favourite in this regard are the drug firms. The American Stock Exchange’s pharmaceutical DRG index was up 27 percent last year. Analysts rhyme off a number of reasons why these corporations should continue to do well: a friendly Republican president in newly elected George W. Bush; an aging population; hearty spending on research and development; and, most importantly, people still get sick in recessions. Perhaps sicker.

While all of these points are quite logical, there are a number of issues that cloud long-term prospects. Competition is extremely stiff, both domestically and internationally, and the generic drug firms are taking a bigger slice of the pie. Patents are tricky to defend, as a recent judgement in which a British court threw out a section of the Viagra patent shows.

As was shown by the crash of many HMOs in the U.S. during the past few years — not to mention our own sorry experience with NovaCare — increasing demand for health care is not in itself a guarantee of success. The resources to pay for this higher demand are limited, and the need to control exploding costs undermines the ability of private enterprise to reap big profits. Marketing costs for new drugs are huge — on the order of a few hundred million dollars a year for a single medication. The industry’s move to do an end run on doctors by advertising directly to the public has increased sales, but at enormous expense.

But aside from how an investor might weigh these pros and cons, there is a more critical factor that clearly indicates that many of these blue chips are heading for a drastic fall. The culprit happens to be precisely the same one that wrecked the pillars of the Nasdaq: inflated earnings expectations. There has been lots of chatter about “earnings warnings” lately, but many investors find it hard to understand how a couple of sentences uttered during a conference call can instantaneously slice a stock’s value by one-third, while at the same time cutting tens of billions from the firm’s market cap.

It seems preposterous that a business could change that radically from one day to the next. And of course that’s exactly right: for the company’s employees, customers, suppliers, etc., it’s business as usual. But for the shareholder surveying his diminishing assets, what has really transformed is the market’s assessment of the company’s growth rate in the future, not its soundness right now.

This reassessment leads to a change of perception; a company that is thought to be strong enough to weather any storm suddenly appears to be fallible. Examples from the past year are legion. Consider, for instance, Intel’s 20 percent drop last September that took place overnight and erased over $80 billion from its market cap. The world’s largest chip company had just announced that its quarterly revenue increase would be only three to five percent — hardly a harbinger of the apocalypse, but definitely enough to prick a bubble of optimism that had sent Intel to an all-time high just five weeks earlier.

The real problem was that the consensus among analysts was that Intel would not only match its spectacular record of the past five years — an average annual earnings growth of 16.5 percent — but that growth would actually accelerate over the next five, to an average of well over 20 percent a year. Huh?? Here’s a company that already almost owns the PC chip market, and somehow it is going to turn on the jets and really start growing? How much better can better get?

These things always seem silly in retrospect, but the reality is that success generates such overpowering momentum, that it requires some kind of a catalyst for the market to say, “Hey, wait a sec, this ain’t going to happen.” So what these warnings actually do is plant the seeds of doubt around a stock that has been “priced to perfection,” and the consequence is a devastating reality check.

So what does all this have to do with drug companies? Well, take a gander at Pfizer, which has a lot of similarities to Intel. Pfizer is the largest manufacturer of pharmaceuticals in the world, with sales of $29 billion. Best known for the erectile fixer-upper Viagra, which has helped make a lot of older guys blissful, the company has a number of other blockbuster drugs, including the cholesterol-lowering medication Lipitor, which has sales of $5 billion a year.

The company has enjoyed a terrific record over the past five years, as earnings have grown by 16.8 percent annually. But that’s dinky, say the analysts, whose forecast for annual growth over the next five years is a tremendous 21.3 percent. Such projections have placed a sky-high premium on the stock — recently the P/E multiple was 69. And enthusiasm for the shares shows no sign of flagging: of the 29 brokers covering the company, 20 have it rated as a strong or moderate Buy. Not a single one has rated it a Sell. Aren’t antidepressants great?

Pfizer is a calamity just waiting to happen. It’s a great company, but it doesn’t walk on water. To match that growth rate, sales would have to zoom to $76 billion by 2005. To sell that much Viagra, they need globalization to include orgies as a weekly rite of passage. Of course, sales need not increase that much if margins can be improved, but not even a Republican president, well greased with massive campaign contributions, would allow for a windfall on that scale.

None of which is to suggest that you should run out and short the stock or buy some puts. The trouble with these overvalued stocks is that they can become even pricier before that catalyst comes along and jolts everybody out of their euphoria with a bucket of cold water. The landscape is dangerous.

We don’t mean to pick on Pfizer unduly; it is only one example of a widespread pattern. Though analysts have drawn in their horns where the next couple of quarters are concerned, further down the road the rose-coloured glasses are as predominant as ever. In the computer networks sector, the five-year growth rate is supposed to better than double from 17.9 percent to 36.7 percent; telecommunication equipment is expected to jump from 20.7 percent to 32.9 percent. Those are mighty impressive numbers.

The Dow Jones held up pretty well in 2000, but several of its components will also find it very tough to justify expectations. In the following list, the first number indicates the actual earnings growth rate for the past five years, while the second figure is the consensus estimate for the next five years: Boeing, 10.1, 15.8; Coca-Cola, 5.2, 13.5; Disney, 3.5, 15.3; General Electric, 13.2, 15.2; Hewlett-Packard, 10.1, 14.8; SBC Communications, 9.2, 13.0; Wal-Mart, 10.3, 14.8. Some of these firms may well achieve these lofty targets, but we’ll be amazed if there aren’t a number of crippling earning surprises amongst this group.

While great expectations can be fun and sometimes lead to wonderful results, it is equally true that unhappiness can be best averted by toning down one’s hopes, so that there is less disappointment when things don’t transpire as envisioned. In our optimistic age, this dreary attitude is out of step with the desire for things to be the best they can be. While we do prefer an upbeat outlook — garnering us the moniker of “optimistic realists” — Panglossian prospects are dangerous in our book. This attitude ensures that if the Dow-doo hits the fan, we won’t be blindsided by false expectations.

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