You know that Phil Town would want you all to invest in businesses you understand. I’m a river guide. What I understand well is pretty much limited to burgers and Harleys, but I do like to venture into things that have a lot of potential from time to time. And I get tips from friends. It’s the tips from friends thing that gets me sometimes. You know, friends who are insiders someplace or at least they know people. My kid knows her friend whose mom used to work there. That sort of thing. Stuff you can really trust. Right. But still.
So here we go on DNA — Genentech — which came highly recommended by friends who built a nice life by getting DNA stock before it went public and selling a bit here and there as it went up to $100. Now it’s dropped down to $70, and unless Genetech is about to hit a wall, it’s looking pretty much like a very good business that is on sale.
Here’s how I looked it over this morning (and I’m using Investools here, just for time’s sake):
I got the chart up and noted that it peaked at $100 a couple of years ago and has been drifting down ever since… and is now at $70. Doesn’t mean much, except that it’s out of favor with the Big Guys. So let’s take a quick look at the industry and see how it’s been doing in the same time frame.
DNA is in the Biotechnology & Drugs industry ($BIOTRX) which, as you can see below, has done pretty well over that two year period, rising from 500 to 650 — about a 14% per year gain.
That means the issues related to the drop in DNA stock of 16% per year while its industry group is rising 14% a year are internal to Genentech rather than industry wide.
Darn. I like to find out that a good business is being hammered unfairly with the rest of its industry. When the industry is doing well and your stock isn’t, usually the problem is one of two things:
- Your stock was way overpriced and it is now being repriced more in tune with its value; or
- There is a perception among the Big Guys that something is wrong in your business.
If it’s the latter and the issue is clear to the Big Guys, you’ll see a very large drop in the price very quickly.
It’s not going to take them 2 years to get out. It’s going to take them a couple of months. A long price slide like we see at DNA is telling us that whatever is going on is probably not a clear-cut problem and may be just a gathering herd of Big Guy sheep following a leader. And if that’s the case, they are going to wake up one day and wonder why DNA is priced so low relative to its value, and then they are going to buy it back up to its value. So let’s take a look and see what that value might be.
Start with looking at the earnings estimates from analysts. You’ll find that on the left menu at MSN Money once you open the main page for DNA.
You’ll notice a fun thing: There are 19 pros who are willing to say that they know what the growth of earnings will be over the next 5 years. And you’ll notice that they have a pretty substantial difference of opinion: their estimates range from 16% to 41% per year EPS growth.
That’s a big gap.
DNA has been averaging 68% for the last 5 years. And last year it grew its earnings 31%. The average of the analysts is at 25%. We could use that for a starter to get to a value. Plug the trailing twelve months earnings into the calculator ($2.55), stick in the 25% growth rate (since historical is higher than that), use a 50 PE (since historical PE is higher than that), use a 15% discount rate since that’s our minimum acceptable rate of return, and hit the button.
I get $294 a share as the value of DNA today. It’s full MOS is half of that — $147. It’s selling for $70, half the MOS. Hmmmm.
Let’s do it again using the most cautious analyst’s estimate for future growth: 16%. That gives us a 32 PE. Plug it all in and we get a value of $89. A full 50% MOS is $45 and a 20% MOS is $72. And it’s selling for $70. Hmmm. Hmmmm.
There is a lot of upside in this business right now. If these guys keep hitting their bigger EPS numbers this thing is going to go sailing upward. On the other hand, how much downside is in this?
We’re getting it somewhat on sale at $70. What that means is that if the most cautious guy is right, in ten years or so the stock will sell for about $360. We bought it at $70. We made 18% a year. Sweet.
So there is only the question of understanding the business that we own. In this case, that seems to me to be quite a job. Not impossible, but significant. I’d have to understand the pipeline of DNA products, how those will compete in the long run with Amgen and the regular pharmas. That’s a lot to try to learn.
Still, it’s really like taking on a term paper. A couple of weeks of work would do the job. I’d know by then if I was going to be okay with this industry as one of my areas of expertise. And I’d know by then what the issues are with DNA. And I’d know enough by then to make up my own mind about their future, put that into a number, put that into the calculator, and get a value that I would feel solid about.
That’s how you do it.
Now go play.
Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.