For many years now, investing in healthcare related stocks has presented me with a conundrum of sorts. Demographic forces, primarily the graying of America (and the world for that matter), suggests powerful future growth potential and demand for healthcare related products and services.

On the other hand, healthcare and its costs have long been a political hotbed.

Consequently, my conundrum has been deciding whether to even invest in healthcare stocks or not.

Healthcare is clearly an industry that promises enormous growth potential, but, healthcare is also an industry that possesses enormous political risks as well.

Not to mention, of course, the perceived Amazon threat.

Over the past couple of decades healthcare related stocks have gone in and out of investor favor numerous times.

Ironically, for many companies in this sector, fundamental results and growth have been stellar in spite of the political risks. Their stock prices on the other hand have also gone in and out of favor many times.

For example, as early as 2 or 3 years ago, best-of-breed drug retailers were being awarded with lavish valuations by Mr. Market (I will provide a clear illustration of this in the video). Even more ironically yet, even the worst performing company, Rite Aid Corporation (RAD) also commanded a high valuation.

However, starting in July of 2015 investment sentiment towards drug retail stocks turned very dark – very quickly. Since that time (July 2015) premier drug retailers have lost approximately 30% to 40% of their value based on stock price. Ironically, these precipitous drops in stock price have occurred at exactly the same time that premier drug retailers such as Walgreens (WBA) or CVS (CVS) were growing earnings by 15% to 20%. This is an obvious disconnect between fundamental results and price action. Prices have fallen precipitously while earnings and dividends have grown at double-digit rates – why?

The answer seems simple and straightforward, and can be articulated in two ways. Number one, this type of disconnect between price and value clearly indicates (to me at least) that valuation must have been out of alignment with fundamental value in the summer of 2015. In other words, the market was either wrong then or it’s wrong now. Number two, something had to cause investor sentiment towards drug retailers to quickly turn from euphoric to despondent.

So when I become aware of precipitous stock price drops like we are recently experiencing with drug retailers, I immediately check valuation first and then I look for any tantalizing news that is being reported by the media. My objectives are also simple and straightforward. I simply strive to answer the questions: Does valuation now make sense and is the current news a real threat or imaginary and temporary? The point is that I do not turn negative on a stock, or positive on it for that matter, based simply on its recent price movements. I focus on fundamentals first and price in relation to those fundamentals next.

The three premiere drug retailers in America represent quintessential examples of how the market price of the stock and its intrinsic value can become disconnected from true worth valuation. Therefore, this article will examine the operating histories and future potential of America’s three most prominent drug retailers-Walgreens Boots Alliance, CVS Health Corporation and Rite Aid Corporation.

Invest in Walgreens or CVS – Speculate in Rite Aid

As the title of this article proposes, I suggest that investors might consider investing in Walgreens or CVS – and possibly speculating in Rite Aid. To summarize my view, I believe that both Walgreens and CVS represent high quality dividend growth stocks that are currently attractively valued for above-average long-term capital appreciation and a growing dividend yield. In short, I consider both attractively valued long-term dividend growth stocks as well as attractive long-term capital appreciation investments. In contrast, I consider Rite Aid an intriguing speculation as a potential takeover target, or simply a potential turnaround opportunity.

Note: As an aside, this is the first article in my 2018 “Principles of Valuation” series. With each subsequent article I will present one (sometimes like with this article two or more) attractively valued research candidates I have screened for in this overheated market that simultaneously represents a quintessential example of a value investing principle.

Although these will be pre-comprehensive research candidates, I will strive to only offer candidates that I believe are worthy of you spending the time and effort towards conducting a more comprehensive due diligence effort. Furthermore, I plan to present research candidates in all categories to include growth, value and dividend growth. The link to my introductory blog describing this 2018 strategy is found here.

Investing Principle: Price volatility is Not Risk Because Not all Price Drops are Equal!

The long history of investor behavior clearly proves that it is undeniably true that stock price volatility can and usually does incite strong emotional responses causing less disciplined investors to react rather than think. To me this is dangerous behavior because I have long held that the emotional response has no place in the investment process. Nevertheless, it can’t be denied that the strong emotions of fear and greed can, and will, temporally dominate investor behavior. Of the two – fear – is the most powerful, and therefore, the most dangerous. Controlling emotions is critical if one expects to succeed in investing.

Knowledge is the best antidote to counter-act emotional poisons. Since investing implicitly deals with the future, trust and patience are absolute requisites for success. However, both trust and patience must be based on fundamental facts and not mere opinion. When the research is properly conducted, I refer to it as intelligent patience. In essence, intelligent patience is trust based on the critical analysis of the facts. In contrast, emotions like fear create panic and irrational behavior, while facts provide insights and clarity. Strong emotional responses cause mistakes to be made, but the investor that sees clearly is the investor that makes the most profitable long-term decisions.

Not All Price Drops Are the Same

Stock price drops are a great case in point. For the emotional investor, all price drops are bad and frightening. This elicits the flight response, causing what are often unnecessary losses to be realized. In truth, some price drops are bad. However, price drops can also spell great opportunity. The discerning investor analyzes the situation and invests with foresight. If the price drop is valid they sell, if unwarranted they buy more.

Today’s post can be summarized as follows: If a stock’s price falls because fundamentals have permanently deteriorated, its expected recovery (if ever) is too long and losses are thus, for all practical purposes, considered permanent. This stock should be sold. If a stock’s price falls because of dangerous overvaluation, it too will take an unacceptable long time to recover and should have been sold when the excessive valuation was first identified. I will provide clear evidence of the veracity of the above statements in the video.

However, if a stock’s price falls from a fair or undervalued level and fundamentals are still performing well, recovery can often be quick. But even if it’s not quick, it is an inevitability that a company’s stock price will ultimately move to its intrinsic value levels. Even better, when you do invest in a stock that is undervalued, you both lower your risk and enhance your long-term returns. In essence, investing in an undervalued stock provides natural and low-risk leverage. In other words, if you pay less for a company than it is worth, in the long run you can earn returns that are higher than the company’s growth rate.

However, it is very difficult for someone in a heightened emotional state to exercise patience or think and behave clearly. Therefore, while the discerning fundamentally oriented investor would see a bargain, the panicky human being can only see risk – even when it’s not really there.

Nevertheless, if fundamentals have remained strong, then the stock is a bargain and should be aggressively averaged down or purchased outright. Importantly, the key factor here is that fundamentals remain strong. Stock prices are often pathological liars, while historical fundamentals such as earnings, cash flows and dividends are actual and real. You can trust fundamental values, but stock prices are pathological liars in the short run. However, in the long run the truth (intrinsic value) cannot – and will not – be denied.

Furthermore, common stocks are liquid securities, which is the primary factor that makes stock price charts so jagged. This incessant volatility within the overall markets would indicate an almost constant level of anxiety with investors. However, anxiety is an emotional response, and as previously discussed, emotional responses tend to be temporary and/or can change quickly.

Nevertheless, if all you focus on is short-term price action, you can be easily led astray. This is simply because stock price volatility is not always rational. At times, a common stock will be overvalued, undervalued or fairly valued. Therefore, short-term price action is not something to predict but something which to take advantage of. As the old adage goes, “Wall Street climbs a wall of worry.” Therefore, I prefer focusing on the fundamental strengths and weaknesses of each individual company I am interested in investing in or that I already own.

Consequently, I am not really as interested in whether the price of the stock is currently rising or falling as I am in how the current price relates to the fundamental value of the business. Knowing the elements of attractive pricing is critical. Therefore, I never let the short-term direction of stock prices cloud my judgment. Instead, I base my decisions on what I believe the company under consideration is capable of achieving on an operating basis going forward. If valuation appears sound on that basis, I am happy to invest. If valuation appears rich, I will avoid or wait for better valuation to manifest or possibly sell if I already hold the stock. Consequently, I rarely see danger in price volatility alone, but sometimes I see danger clearly when I examine fundamental values closely.

To Invest Successfully a Comprehensive Research and Due Diligence Process Is Critical

Before I lay my money down on any stock, I routinely conduct a comprehensive research and due diligence process. However, before I spend the time and effort to thoroughly research the stock, I must initially determine that it appears attractively valued. It makes no sense to me to waste my time learning about a great company that the market is egregiously overvaluing. Therefore, my initial screen is to first determine whether or not the current price quotation represents a fair valuation.

Once I have determined that valuation appears attractive, my next step when researching a company is to start with basic financial value measurements, such as price to book, price to earnings, price to cash flow, and solid balance sheets, etc. As a result, as soon as I have identified something that may have value, it is time to begin a comprehensive research and due diligence process.

My underlying objective is to conduct deep fundamental research from the standpoint of really understanding the company in relationship to the industry it is in and how the market typically values companies in that industry. This is a clear example of the value that can be derived from reviewing historical operating results. However, I will not spend that time and effort unless I believe that the company is currently attractively valued.

Thus, in addition to understanding the market’s normal valuation of the company, my analysis is further oriented towards coming to understand important attributes of the company, such as management’s stewardship, the company’s technology advantages, their financial statements, and the long-term history of its earnings and/or its cash flows, etc. It is not that complicated, but it is comprehensive fundamental research – and I don’t believe there is any substitute. However, it does take time and effort which I don’t want to waste on a company that is too overvalued for me to invest in.

I feel this way because the primary objective of value investing entails buying what is safe and cheap. Safe refers to the viability and survivability of the business as an ongoing concern. Safety is measured by evaluating the strength of the company’s financial position without any regard or consideration of short-term price volatility. Cheap means that the current price represents a significant discount to the company’s value as a private concern or a takeover candidate.

This primary objective of value investing is important because competent value investors view equity holdings as permanent or at least semi-permanent commitments. In layman’s terms, value investors are most interested in positioning themselves as long-term owners/partners in wonderful businesses that were initially purchased at attractive valuations. Therefore, value investing decisions are driven by valuation as it relates to the quality and quantity of resources and the long-term wealth creation potential they offer.

The moral of the story is focus on the fundamental strengths of the company and its valuation relative to those fundamentals, and then draw your conclusions about short-term price action on that basis. The venerable investor Marty Whitman, whom I have quoted in numerous articles, also offered this nugget of wisdom:

“In value investing, the goal is to determine a business’s worth and its possible or probable dynamics, all independent of the price at which the common stock issued by that business trades.”

FAST Graphs Analyze Out Loud Video: WBA, CVS and RAD

The following FAST Graphs Analyze Out Loud Video will examine the historical operating histories of the three widely recognized US drug retailers: Walgreens, CVS Incorporated and Rite Aid. In addition to evaluating how successfully each of these premier pharmacies have performed as operating businesses, this video will also carefully evaluate the relative valuations of each company as well as their future prospects for growth as operating businesses.

They are many so-called investors that eschew reviewing historical fundamental operating results on the notion that history is merely rearview mirror thinking or 20/20 hindsight.

I believe they are drastically short-changing themselves.

Although it is true that we can only invest in the future, it is equally true that we can learn a great deal from carefully examining the past.

Because, as Sir Winston Churchill so eloquently put it: “Those who fail to learn from history are doomed to repeat it.”

But, there are also very practical and insightful lessons that can be learned about the quality of the business’ products, its management, and how well its products are perceived by the marketplace. Achieving consistent long-term success cannot be accomplished by accident. In contrast, anomalous short-term results (good or bad) can prove misleading.

Consequently, studying a company’s past achievements can, and does, provide significant insights into the quality and the long-term opportunity that the business offers. Moreover, success leaves clues, and by studying a company’s history, the clues to its success can often be revealed.

However, at the end of the day, and regardless of the company’s historical achievements, as investors we can only invest in the future. Therefore, all buy, sell or hold decisions should be based on your rational forecast (expectations) of what the company is capable of achieving in the long-term future relative to its current value. Additionally, you should run the numbers based on your rational forecast out to their logical conclusion.

In simple terms, I am suggesting that you should calculate specific rates of return expectations based on your forecasts relative to historical normal valuations that the market has applied. In other words, don’t just hope it’s a good stock, instead, have a clear and rational expectation of the precise results (best case, worst case, mid-case) that your investment could achieve. Finally, continuously monitor the company’s ongoing operating achievements. When doing this, don’t focus on what the price of the stock is doing; instead, closely scrutinize each financial report when it is published. Be on-the-lookout for any permanent deterioration you might see with the company’s long-term fundamental opportunity.

With this following video I will also clearly articulate the rational expectations for the future rates of return that each of these prominent drug retailers might be capable of producing going forward.

Note: Since I am covering three companies in this video, I will limit my historical focus to earnings and cash flow achievements and place greater emphasis on future forecasts. The central idea is to present potentially attractive research candidates that are worthy of the time and effort to research more thoroughly.

Summary and Conclusions

I believe it’s an undeniable reality that stocks in the general sense (the market) are highly valued today. However, that is not to say that all stocks are overvalued. With this article and video I presented two premier drug retailers that I believe are attractively valued dividend growth stocks with good potential for future growth. Additionally, I provided a third drug retailer that represents an interesting speculation. Consequently, my recommendation is that these companies are worthy of the time and effort required on your part to decide whether they fit your portfolio or not.

The moral of this story, and from my perspective the moral of all investing stories, is that valuation matters and it matters a lot. Price and value are not the same. But perhaps most importantly, not all stocks are the same. Even in today’s overheated market good value is there to be found if you’re willing to look and if you’re willing to keep your emotions in check. If you want to sleep well at night, train yourself to becoming a long-term fundamentals oriented value investor.

— Chuck Carnevale

Source: FAST Graphs