Why I Am Now Interested In CVS Health Corporation
Investing in great companies sits at the core of my investment philosophy. In this regard, I reject the idea that I invest in the stock market. To me, the stock market is simply the store I shop in to purchase interests in fine businesses. In the final analysis, my investment objective is to become a long-term shareholder/partner in a business that I believe can make me money over time.
On the other hand, no matter how great I think the business is, I am also very focused on only investing in it at a fair price. When looking for great businesses, this can at times be a problem. Great businesses attract investors, and since stocks are liquid instruments, the forces of supply and demand can have a significant impact on valuation over the short run. In other words, the demand for great businesses is typically high.
Nevertheless, time is the equalizer where in the long run a company’s stock price will be driven by its business success. When dealing with stocks, the common measuring sticks are earnings, cash flows and dividends – if a company pays one. Consequently, because of the supply/demand dynamics over the short run, a company’s valuation can be temporarily out-of-sync with its business success.
Therefore, to my way of thinking, the trick to long-term investment success is to identify a great business and then invest in it only when the market offers it at a fair or attractive valuation. You can overpay for even the greatest company, and if you’re diligent you can also find times when it is fairly valued or even undervalued. I am content to buy a great business at fair value, and I get quite excited when given the opportunity to invest at a low valuation. I have recently become interested in CVS Health Corporation (CVS) because I believe the market has recently provided an opportunity to invest in it at a fair price.
CVS Health Corporation a Great Business at a Fair Price
Before I delve into CVS Health Corporation’s valuation, I would like to establish why I consider it a great business from a shareholder’s perspective. For starters, I really admire the consistency of operating results that the company has generated. The following F.A.S.T. Graph plots the company’s earnings and dividends since 2000 through 2015. Note that I chose this timeframe because it includes both of our most recent recessions. It is very rare to find a company that has so consistently grown its earnings and dividends over time. Moreover, in addition to consistent growth, CVS’s growth rate has also been significantly above average.
CVS has grown earnings at the compound annual rate of 12.5% since 2000 versus the S&P 500 which has only grown earnings at the rate of 5.4%. As I will later illustrate, CVS’s stronger earnings and dividend growth has led to significantly higher returns than the market over this timeframe. Importantly, both capital appreciation and cumulative total dividend income have been superior with CVS. This illustrates my basic definition of a great business. A great business is one that has proven itself to grow faster and more consistently than the average company. CVS represents a quintessential example of that standard, as illustrated by the following earnings and dividend graph.
To further clarify this distinction, I also offer a similar graph on the S&P 500 plotting earnings and dividends over the timeframe 2000-2015. Not only have the S&P 500’s earnings grown at less than half the rate of CVS’s earnings, the overall market’s earnings has also been significantly more cyclical. The market’s dividend record is a little better, but dividends were cut in 2009. When stacked up against the average company, I consider CVS a great business.
As I indicated in the introduction, in addition to identifying a great business, I also want to see it at an attractive price. On these next two graphs I bring in monthly closing stock prices for both CVS and the S&P 500. It’s important that the reader recognizes that both CVS and the S&P 500 were overvalued in 2000. For those that recall, calendar year 2000 represented the coming to the end of what was dubbed the “irrational exuberant period” in the stock market. Consequently, I would’ve had no interest in investing in either at this time.
Furthermore, the reader should also note that both of these entities were also overvalued at the end of calendar year 2015. Consequently, I had no interest in investing in either of these entities during calendar year 2015. CVS continued to perform strongly on an operating basis, but stock price was so disconnected from fair value (the orange line on the graph) that I had no interest in spite of its impeccable operating record.
The following performance report compares CVS versus the S&P 500 over this timeframe. What I found interesting is how both CVS and the S&P 500 produced capital appreciation returns that were lower than their respective earnings growth achievements. This is the effect that overvaluation had on both.
On the other hand, the great business CVS was still able to produce very attractive double-digit total returns thanks for the most part to its high and consistent growth. In contrast, the S&P 500 produced positive results but they pale in comparison to CVS. The simple lesson here is that valuation matters, and it matters a lot.
Now let’s fast-forward to current time and evaluate what CVS looks like today from a valuation perspective. Since the summer of 2015, and for most of 2016, CVS’s stock price has been in a freefall. The net result is an approximately 23% drop off from its 2015 summer high. Investors hate it when a stock’s price drops, and as a result it typically conjures up a lot of negativity.
In doing my research on CVS I have come across several recent articles on the company, most of them positive. However, some of the comments made in these articles illustrate my previous point about negative investor sentiment. Reasonable questions start to be asked such as – if the stock is so good, why does it keep dropping? But more importantly, answers to those questions are also offered. Some of those answers are relevant; some are rationalizations – and some even cynical laments with political overtones.
I support the proposition that everyone is entitled to their own opinions and views. However, to me, the answer to the question of why is the stock dropping seems quite obvious. It is quite clear to me that starting in the fall of 2014 the company’s stock price began separating from its fundamental value and support. In my experience, when valuation gets extreme, a company’s stock price becomes highly vulnerable to even a whiff of bad news. Furthermore, the more overvalued a stock is, the more vulnerable.
For example, in the case of retail pharmacy chain and pharmacy benefit management businesses such as CVS Health Corporation and Walgreens Boots Alliance, Inc. (WBA) the threat of rising pressure to reduce reimbursement fees for generic drugs is seen as a potential threat to future profitability. Additionally, stiff competition is also a challenge that must be met.