In the March 2013 issue of Investor Advisory Service we continued our theme from February, "The Great Rotation" into stocks. January 2013's 5.2% gain for the S&P 500 was the best start to a year since 1997. U.S. stock funds took in $36 billion during January, the highest monthly intake ever. Vanguard Group, Inc., the country's largest mutual fund group, beat its previous best-ever inflows for a month by an astounding 40%!
Corporate earnings for Q4 2012 were streaming in when we published our March "Investment Comments," and despite the strong stock market, company performance seemed totally bipolar. Year-end 2012 results generally outpaced analyst expectations. On the bright side, with two-thirds of S&P 500 companies reporting, average sales growth was 5.9%, with average operating earnings up 7.3%. However, companies’ forward guidance for 2013 was extremely muted. According to FactSet Research, for every S&P company that raised its Q1 2013 guidance, four companies lowered guidance. That 4:1 ratio of bad to good represented the highest disparity since FactSet began tracking the statistic in 2006.
The economic picture remained mixed. Q4 2012 GDP growth was initially measured at -0.1%, which was later nudged up to a revised figure of +0.1%. However, the underlying components behind that aggregate GDP number seemed to be improving. Inventories came down during Q4 2012, implying pent-up demand for manufactured goods. Consumer spending, the most self-sustaining component of GDP, increased 2.1%. Within the consumer category, automotive sales and existing home sales were particularly strong, up 7% and 13% respectively.
With the macro picture cloudy, we relied largely on valuation to support our bullish view. We summed up our overall stance toward the stock market as follows:
Given the strong gains in the market since the lows of March 2009, are investors jumping in at the wrong time? We don't think so. According to Liz Ann Sonders, Chief Investment Strategist at Charles Schwab & Co, the S&P 500’'s trailing 12-month P/E ratio is 14.4, about the market’s long-term average. As we scan the market for investment selections we also don't see the easy buy candidates that we did a few years ago. This seems to be a normal market with valuations that are not unreasonable.
We were right to remain bullish. Now twelve months later, the S&P 500 is up over 20%!
Let's take a closer look at one of the companies featured in the March 2013 issue: Gilead Sciences, Inc. (NDAQ: GILD). Famous for its work on the drug "cocktails" that have turned HIV and AIDS, once effectively a death sentence, into a much more manageable disease for millions of infected people, Gilead is one of the world's great modern pharmaceutical companies. Historically, the company's specialty has been its focus on viral diseases, a relatively neglected corner of the pharmaceutical world. Gilead's HIV franchise is basically perceived as bulletproof, but investors have criticized the company for failing to produce great blockbusters outside of that core franchise.
We have followed GILD in the Advisory Service since February 2007. During its early stint in the IAS, the stock never caught much traction, remaining stubbornly flat as its ever-rising earnings were negated by persistent "P/E compression." Investors seemed to be treating the HIV franchise more and more like an asset in gradual runoff mode, which we consider unfair because Gilead continues to innovate and increase its own market share within the HIV space. However, consensus rules in the market, at least in the short run.
Consensus opinion started to change around the beginning of 2012, when GILD shares suddenly took off like a rocket. The proximate cause was its acquisition of Pharmasset, a pre-revenue company developing a pill to treat, or even cure, Hepatitis C. After some early post-acquisition volatility, Gilead shares nearly doubled during 2012 as positive Hepatitis C test results started streaming in.
At the beginning of 2013, we thought GILD had further room to run, so we presented it as a feature company in the March 2013 issue at a price of $40.90. Based on 17% expected EPS growth and a high P/E of 26, we thought the price could go as high as 93 within five years. We modeled the low price as 26, the product of 2012 EPS of $1.64 and a low P/E ratio of 16. That's a very wide range, but we thought a wide range was appropriate, given the lingering uncertainty around the newly-acquired Hepatitis C franchise.
Since that writeup, Gilead has continued to reward investors, nearly doubling again during 2013. At a recent price of $78.40, shares have returned 92% since the time of selection, nicely outperforming the S&P 500's 21.5% total return during the same period. The company's pill-form Hepatitis C drug, named Sovaldi, started selling in late 2013, after its terrific trial results earned it an expedited review and approval from the FDA. However, GILD shares' upward trajectory has also come thanks to solid performance in its HIV franchise.
After increasing almost 300% in two years, GILD shares may finally be due for a correction. However, if there's one thing that Gilead's amazing blitzkrieg against Hepititis C ought to prove, it's that investors need to be on the lookout for any opportunity to bet on a proven winner in the pharmaceutical space. We don't follow many big pharmaceutical stocks, and we try to maintain very high standards for the few that make the cut. When pharma stocks we like go out of favor in the market, a future opportunity may be starting to swell.