These Stocks Are Still Solid Long-Term Picks

Jarrod is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Confirmation bias – one of the psychological traps investors can be most prone to falling victim to. What happens to us as investors when we are influenced by this bias is we essentially discount all information that counters our established view point. If we are bullish on a particular stock, then confirmation bias will mean we will tend to overemphasize the importance of bullish news relative to bearish news. Confirmation bias is one the psychological mechanisms that can underpin the proverbial Permabull / Permabear.

Large cap Pharmaceuticals is a sector where I see good value. One of the reasons (besides excellent company specific fundamentals) is I believe the industry has been subject to the effects of Confirmation Bias.

Witness firsthand the effect of Confirmation Bias

Eli Lilly (NYSE: LLY) is a company whose stock price was greatly affected by Confirmation Bias. In early 2011, there was a great deal of commentary about the ‘Patent Cliff’ that Eli Lilly was facing. A number of patents were due to expire in 2012. The broad sentiment seemed to be that this would materially impact the performance of Eli Lilly and that that would mean significant declines in the stock price.

This is classic Confirmation Bias, the popular commentary surrounding the stock was fixated on one single issue (albeit a concerning one). Because of this, the consensus seemed to be that Eli Lilly was going to struggle going forward, and it should be priced accordingly.

On the surface, this appears to be quite a rational viewpoint. For a company that derives a good portion of its profit and earnings from patent-based products, expiring patents should be cause for concern. Except most investors missed one key thing – the rest of the market seemed to be thinking this very thing. One has to wonder if the collective market and commentary appears to be in agreement on the prospects of a stock, is it then reasonable to assume those prospects may well be fully (if not excessively) priced in?

As it turns out Eli Lilly began steadily climbing in spite of the ‘Patent Cliff’. From a low of $35, it has climbed to over $55. This 55% plus rise has probably occurred at the bewilderment of many commentators because it has occurred as Patents have been expiring.

This strong performance provides a great lesson for us as investors. It illustrates that fundamentals are important, as is understanding the market sentiment pertaining to our selections.

I think that there are two more excellent buying opportunities in Pfizer (NYSE: PFE) and Merck (NYSE: MRK) for similar reasons to the performance we have seen in Eli Lilly.

The unassuming giant

Pfizer, as I see, it has excellent metrics. With a forward price to earnings ratio (PE) of 12.3, debt to equity of 46%, interest cover of nearly 9 and free cash flow of $3 per share, Pfizer is a solid company that is producing an excellent amount of cash earnings.

Pfizer recently announced it first-quarter earnings which disappointed analysts. As a result, Pfizer has recently sold off about 6% from its recent peak of $31.15. Despite results that were not outstanding, Pfizer continues to impress me. The metrics and earnings power of this company seem a bargain at a forward PE of less than 13, especially when compared to the current PE of the S&P 500 of 18 times.

What impresses me about Pfizer is that it has a pipeline of new products that is both broad and deep. A great number of potential products are in various stages of trials. A key strength of Pfizer is it is not just relying on one specific trial. There are several high profile potential drugs that are being worked upon, but there is considerable breadth in the potential pool of new revenue sources. The success / failure of Pfizer does not hinge on any single drug. Of course, there are a select few that generate outsized profits, however, the suite of products it offers is what underpins Pfizer’s strength.

I see a similar situation with Merck 

Merck recently announced its first-quarter earnings, somewhat disappointing analysts. The result so far has seen the stock price come off by about 6%. Whilst the earnings may not have met analyst expectations, it is important to not buy into the notion (Confirmation Bias), ‘Oh well, we knew it – the growth in big pharma is over, dump the stock’.

Merck, just like Pfizer, is a cash generating powerhouse. Its dividend yield is an attractive 3.80%. It is trading at a forward PE ratio of less than 12 and has an interest cover of a whopping 13.2. I think it is reasonable to say Merck is a financially sound and effective business.

As with Pfizer, what I like about Merck is the breadth and depth of their product pipeline. At a forward PE of 12, Merck seems cheap to me. It has a number of high quality products that are deeply entrenched in their niche markets as well as their pipeline of over 50 potential products at various trial stages. To me, Merck only needs for just a small handful of these potentials to turn out successful and a PE of 12 will suddenly seem grossly undervalued.

After all is said and done, what I (and I hope readers) takeaway from this analysis is that is it not the next 90 days that we, as long-term investors, need to be concerned with. Even the best, most well run companies can have a quarter that is not ideal. As long-term investors it is important to ensure we don't overemphasize short-term performance. Maintain your focus on the long-term, that is where the value will come from. Leave the short term gyrations to traders!

Is Eli Lilly a buy or sell?
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Jarrod Bailey has positions in both Pfizer and Merck via Jan 15 Call Options. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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