BITS > JULY 2003

Improving Company and Industry Comparisons

Editor's note: Effective comparisons can be a meaningful part of our stock studies. Maintaining an awareness of industry averages and trends can provide support for judgments about growth and profitability expectations. BITS has presented a series of industry studies over the last year or so. This article examines the potential for using peer groups with our Stock Selection and Stock Comparison Guides.

We all perform peer group analysis almost every day.

We make non-stop comparisons in routine activities like watching gasoline prices (per gallon) or shopping for a box of cereal. We compare all prices to something -- that is, unless we're talking about our son, Alex, and Honeycomb cereal. Honeycomb gets special consideration and I'm not sure that the price could ever matter.

Real estate provides one of the better examples of comparison technique that is very similar to investment analysis. Think back to your last residential purchase. Chances are you went through a process of comparing size and features for a group of houses. Real estate appraisers generally will use price per square foot for these comparisons. A 2000 sq.-ft. house selling for $100,000 has a price-to-size ratio of $50/sq. ft. The amenities and features for a particular house will influence this figure up and down, but by far the greatest influence on price-to-size is location.

A residence selling at one location for $50/sq. ft. might shift to $100/sq. ft. (doubling in asking price) just by picking it up from its foundation and moving it to another location. Don't try this at home. Your spouse might have you committed if he or she finds you jacking up the corners of the family abode. Leave this one to the professionals. Make sure your spouse is aware of the project before the big truck pulls up in the driveway.

It's a short jump to stock analysis. Instead of price-to-size, we use a comparison factor based on price-to-profitability known as price-to-earnings or P/E ratio. The influences are different, shifting to key determinants of quality (sales growth, profitability and consistency.) But "location" still matters. In the case of common stocks, we make comparisons to other related companies. How fast are the peers expected to grow? How profitable are the other companies that operate in similar or identical markets? Where might the best comparisons be found?

Industries or Peers?

In the Maslow series of industry studies published in BITS, we've used industry groups for comparisons. To my knowledge, there are no perfect groupings of company comparisons, but I'll be the first to admit that I have a hard time comparing O'Reilly Automotive (an aftermarket auto parts retailer) directly with Bed Bath & Beyond simply because somebody says they're both retailers.

When comparing fundamentals like expected sales growth and profitability, it makes sense to search for apples-to-apples situations. It's probably OK to settle for oranges-to-tangerines.

In the accompanying table (Figure 1), the pharmaceutical industry has been divided into five peer groups: drug delivery, diversified, generic, major drugs and specialty. The source of these peer groupings are the Standard & Poor's tear sheets which include their industry analysis pages.

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Figure 1. Figure shows the pharmaceutical industry subdivided into five peer groups: drug delivery, diversified, generic, major drugs and specialty. Companies in each peer group are ranked by an estimate of their quality (far-right column, highest-to-lowest) with averages calculated for key fundamentals. Note the differences in peer-group averages. Sales Growth - 3-5 year forecast estimates from SSG studies. Net Margin - expected net margin in the next 3-5 years from SSG studies. P/E Avg. - expected average P/E forecast in the next 3-5 years from SSG studies. Financial Strength - Value Line's rating for the company, ranging from C (0 percent) to A++ (100 percent). EPS Predictability - Value Line's rating for the company, ranging from 0 to 100. Challenge Quality - calculated from relative sales growth, relative profitability, financial strength and EPS predictability from Mark Robertson's studies (ranges from 0 to 100). Sources: Value Line Investment Survey and personal SSG studies and estimates by Mark Robertson.

Drug delivery and specialty drug companies are growing faster than the other three peer groups. Intuitively, this makes some sense. Likewise, the profitability characteristics for generic drugs are different.

Some of the groupings also seem to fit better for purposes of comparison. For example, some NAIC investors have expressed reservations about comparisons between Abbott Labs and Pfizer. They're both grouped by many research services to be in the same industry, but the businesses have different components. While not dramatically different, a comparison between Abbott Labs (ABT), Johnson & Johnson (JNJ) and Bristol-Myers Squibb (BMY) may seem more appropriate to some.

Central North Carolina Chapter Director Dan Hess wrote, "I think this grouping is more representative than the competitors Hoover's shows for JNJ, which are Merck, Novartis and Procter & Gamble. JNJ is an example of a challenging comparison. My main intent during a stock comparison study is trying to measure quality or just see how a company is doing versus its peers."

Dan continued, "While JNJ, BMY and ABT are clearly not full peers in all of their product lines, I think this side-by-side comparison is far more representative than comparisons made versus the entire pharmaceutical industry. Since in most cases, any two companies will usually exhibit differences of varying degrees, it will always be necessary to condition individual judgments as opposed to any purely mechanical mathematical approach."

Constant Change

We recently noted that S&P Compustat had shuffled some industry groups, moving Wal-Mart, for example, into a new industry group known as hypermarkets and supercenters. Industry and peer groups are clearly not static. Hugh McManus asked if SIC Codes were explored in order to support these peer groupings. We discovered that the companies listed in Figure 1 all have the same SIC Code. Therefore, although this may have worked for some sectors or industries, it fails to provide the granularity that we seek. In Hugh's words, "Industry and peer group comparisons will always be a challenge so long as Wall Street is creating the categories. You should see what it does with Biotech."

Support for Stock Studies

BITS and Better Investing have featured Pfizer case studies by Hugh McManus over the past couple of years. In those studies Hugh has expressed reservations about forward-looking growth rates for the major drug firms. Hugh's Pfizer sale growth forecast (low single-digits) has been a favorite subject of animated debate within the NAIC online community.

Even after factoring in the acquisitions of Warner Lambert and Pharmacia, many NAIC investors seem willing to estimate future sales growth at 10-12 percent for Pfizer. Hugh urges caution. 10-12 percent sales growth may actually materialize for Pfizer. A closer look at Figure 2 might help us see where Hugh's coming from as a pharmaceutical industry professional. Note the tailing off of the expected sales growth rate, from 10-11 percent, to estimates now approaching 7 percent. In Hugh's view, this overall peer group outlook should at least influence our forecast selections on our Stock Selection Guides. He found the differences between expected growth rates and profitability for the various peer groups to be "most enlightening."

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Figure 2. Figure shows changing expectations over the last nine years for the future growth, profitability and P/E levels of major drug companies. The companies are Pfizer, Merck, GlaxoSmithKline, Novartis, Wyeth, Schering-Plough and Eli Lilly. The fundamental factors shown here were calculated using revenue-weighted averages, calculated on a quarterly basis for the period shown, using Value Line data and SSG studies and estimates by Mark Robertson. Sales Growth (left axis) - 3-5 year forecast estimates from SSG studies. Net Margin (left axis) - expected net margin in the next 3-5 years from SSG studies. P/E Avg. (right axis) - expected average P/E forecast in the next 3-5 years from SSG studies. The important point here is that investor expectations can and do change over time. Regular updates of SSG studies can help identify them.

How will this influence your thinking about forward-looking growth rates for the major drug companies?

A Paragon of Profitability

The Pfizer story and on-going analysis also mandates some attention to expected profitability. As shown in Figure 1, Pfizer has one of the highest expected net margins in the pharmaceutical industry. It's not an accident that Pfizer ranks as a widely-held company among NAIC investors. Pfizer's profitability trends have remained strong throughout the Warner Lambert and Pharmacia transactions. How high can the margins be maintained? What are your estimates based on the comparisons available in the table?

Hugh also expressed some surprise that the net margin expectations for the major drug companies seemed to be holding up fairly well and certainly better than the sales growth expectations.

Figure 3 provides this historical profile for the diversified pharmaceuticals companies. Note the steeper decline in margin expectations (versus the major drugs peer group in Figure 2.)

Click to enlarge.

Figure 3. Figure shows changing expectations over the last nine years for the future growth, profitability and P/E levels of the diversified drug companies. The companies are Johnson & Johnson, Abbott Labs and Bristol-Myers Squibb. The fundamental factors shown here were calculated using revenue-weighted averages, calculated on a quarterly basis for the period shown, using Value Line data and SSG studies and estimates by Mark Robertson. Sales Growth (left axis) - 3-5 year forecast estimates from SSG studies. Net Margin (left axis) - expected net margin in the next 3-5 years from SSG studies. P/E Avg. (right axis) - expected average P/E forecast in the next 3-5 years from SSG studies. As in Figure 2, the important point here is that investor expectations can and do change over time and regular updates of SSG studies can help identify them.

It's also interesting to chart the average expected P/E ratios over time. Both peer groups suggest a decline in expected P/E ratios. What influence does a decline in expected sales growth rate suggest for these aggregate P/E ratios?

Bridges to Judgment

How might this information be useful? For one thing, knowing the relative growth rates for generic pharmaceuticals (9 percent) will naturally have some influence on my studies and forecasts. If I'm selecting a forecast that's head and shoulders above the rest of a peer group, I'm probably going to want some assurances that history and expected operating results are on my side. If a company has extraordinary profitability, my study will urge me to consider the sustainability of the advantage. Is patent protection in place? When does patent protection expire? What are reasonable growth and profitability expectations for a particular peer group?

The challenge approach to portfolio management encourages NAIC investors to replace companies with equal or higher quality when making switching decisions (while improving the overall expected return of the portfolio.) The drivers of quality (relative sales growth, profitability, financial strength and consistency) are visible in Figure 1.

I think Maslow would be warm and cozy with this kind of peer pressure.

Mark Robertson is director of online resources and senior contributing editor for BetterInvesting. He serves as a member of BetterInvesting Magazine's Editorial Advisory & Securities Review Committee. Mark can be reached at Robertson_Mark@comcast.net.