PFE & Behavioral Finance

Alexander Motola, 2013 1

PFE & Behavioral FinanceAlexander Motola, CFA


Pfizer Inc. – BuyPFE is a global pharmaceutical company involved in the research, development and marketing of drugsRelevant Facts:- PFE has

historically been an aggressive buyer of stock

- PFE pays a strong dividend

- PFE has been acquisitive

Company- 80% GM- 3% Yield- -12% Rev

Growth- $206B Mkt

Cap


Investment Thesis PFE continues buying back stock through

my target horizon of 2017, reducing share count from 7.5B in 2012 to 5.2B in 2017

PFE continues to pay $7B annually in dividends; this coupled with the buyback, will cause dividends to grow from $0.88 in 2012 to $1.36 in 2017

PFE has been trading on its dividend yield, currently 3%; if it can trade at 3% in 2017, that’s $45, or 9% per year in appreciation, plus 3% per year in dividends

This represents a solid but unspectacular return, but 25% of the return is paid while you are waiting (dividends), and the data to track the progress of thesis is easily available


Investment ThesisAdditional Upside

More cash devoted to buybacks or dividends

Return to revenue growth sooner than expected

PFE could trade closer to its historical yield of 2.25%

Risks Big acquisition Cash flow declines Management

changes focus from returning cash to shareholders

Underinvestment in R&D

RecommendationBuy 1.5% PFE, hold until 2017; re-evaluate

at the target price


What I thought I knewPFE is negative growthPatent cliff represents a

substantial issue and has depressed the multiple for a long time

Most/Many investors own it for the dividend


PFE – First StepsPFE Website

◦Conference presentation◦Transcript◦Annual Reports

Started Income Statement (Historical, Annual)

Need Yahoo! Finance for Prices going back to 2003 (High and Low)


PFE – Second StepCalculate valuation

◦P/E on current year ◦P/E one year (A) ahead and two years ◦P/S◦Dividend Yield

What I’ve learned (new)◦Acquisitions are a big part of the story◦WYE particularly important◦Accounting isn’t completely clean◦Dividend was cut in 2009


PFE – Third StepAnalyze What I Have

◦Dividend bias appears confirmed◦Investors discounted the dividend cut in

2009◦Share Count reduction is significant◦Is it possible to return $20B to investors

each year (33% dividends, 67% buybacks)? Can PFE afford it?- Cash generation analysis

Look at YTD performance and filingEnhance model w/ CFO presentation


PFEAdjusted Model Forecast

◦Based on CFO’s comments- Cash generation analysis

Look at YTD performance and filing

Enhance model w/ CFO presentation


PFEWish List at this point: Valuation history on forward

estimates Would love to get historical data on

the drugs individually (I’d ideally pull it from a sell side model and then review it for accuracy)

Bloomberg “CACS” function, which allows you to analyze acquisition timing and amounts

Analyst Reports A second monitor!


PFECFO’s comments on 9/10/13 @ the Morgan Stanley Healthcare Conference:

“If you look at our revenue and you look at the rhythm of our revenue in terms of what our revenues are doing, over the last few years our revenues have been declining. And take out the divestments that we've been doing. If you normalize, our revenues have been declining. They've been declining because of patent expirations. Last year, we had almost $8 billion, almost $8 billion of patent expirations really being driven by Lipitor in the US and Europe. This year almost $4 billion, and the next couple of years $3 billion to $4 billion a year. So we've got that headwind probably for the next couple of years. So that's a negative. [basis for my declines in revenues through 2017]

But if you look at some of the positive factors in our revenue, there are several. So one is we have in-line products, some in particular that are performing very well, products like LYRICA, that continue to perform well. If you look at our emerging markets, our emerging markets continue to grow. Some of our markets, like China, are growing very nicely. Last quarter 15% to 16%, and that's after adjusting for price. So literally up 15% to 16%.

And then the other thing now is new products. And as we work our way through this process, it's not just the new products we have but advancing the pipeline, creating more revenue from more new products, and then bolting, supplementing with business development. [Pipeline + Emerging + modest acquisitions should get growth going post 2017, I’ve modeled a small pick up in growth, about 3% per year; given more time, I’d get more granular, and analyze the $500MM and over drugs individually]

So when you think about the rhythm of the revenues, we've got headwinds. We're going to have that for the next couple of years, but we've got some positive factors within that that I think are helping the business. I didn't mention Consumer. I could mention some other ones, but those are the big-ticket items.”


PFECFO’s comments on 9/10/13 @ the Morgan Stanley Healthcare Conference:

“If you think about what we're doing in share buybacks, this year I've said we'd do the mid-teens billions in buybacks. If you take that plus the dividends we're going to pay out this year, we'll return directly to our shareholders over $20 billion in cash this year, just in terms of some of the things that we've been doing. The intent going forward is to continue to do those kinds of things to mitigate as much of the impact of revenue on the bottom line as we can. And I think our track record has been good, and going forward our intent is to continue to do those things to mitigate as much of it as we can.”


What else would I do?Full Cash Flow Statement, Balance

SheetQuarterly Income StatementsModel each major drugTalk with sell side analysts and the

company, especially focusing on the buybacks and dividends

Look at global peer group and see if there’s a better idea or another idea

Get extremely granular on the model

Read all filings and transcripts


PFE: Written AssignmentPFE faces several challenges, including revenue declines driven by patent expiry on major drugs, some questionable accounting practices, potential pension issues, and the risk of overly aggressive M&A activity.

Patent expiry has crushed PFE’s largest drug, Lipitor. In 2008, Lipitor generated revenues of over $12 billion for PFE, but in the most recent complete year, 2012, Lipitor – now generic in every major market – brought in only 1/3rd that. Although the magnitude varies by drug, this is an issue PFE continues to face in a material way over the next several years for a variety of drugs, and revenues will continue to decline through 2017.


PFE: Written AssignmentPFE aggregates several “below the line” items, such as interest income and interest expense, in “Other” – which falls into Operating Expenses as they report it. This is unconventional and, in my opinion, inappropriate. PFE also has a relatively low ADA of $374mm USD. The company is owed in excess of $1.2B USD from government/government agencies in Italy, Spain, Portugal, Greece, and Ireland; $274mm of which is past due in excess of one year. Additionally, PFE’s total pension obligations are underfunded by over $10B USD, and their expected return on plan assets varies between 5.9%-8.5%, which are unrealistic assumptions in my view.


PFE: Written AssignmentMy recommendation is based on PFE continuing to grow their dividend. Over the past 10 years, the dividend payment to shareholders declined once, during the financial crisis and in advance of the acquisition of WYE, a major event for PFE. During this period, although the stock price was low (less than half of current prices), buybacks ceased. I think a major acquisition would likely be a negative for shareholders in both the near and long term.

PFE has continued to grow dividends and buy back stock in spite of declining revenues. Much of this has been driven by operational improvements, such as improved efficiency of R&D and consolidating the manufacturing footprint globally. Lipitor was such a huge part of revenue (25% of total revenues in 2008) but now no drug is > 10% of revenues, so the single drug risk and patent expiry impact is more limited.


PFE: Written AssignmentShares outstanding ended FY12 at 7.5 billion and currently stand at 6.5 billion. I think this number will be 5.147 billion or less by 2017. This reduction in share count supports a strongly improving dividend on the same cash payout (roughly $7 billion USD) over that time period.

PFE, 10 years ago, had a dividend yield of approximately 2.25%, but currently trades at a 3%. Just before the dividend reduction, which I believe was anticipated by the market, PFE traded at 8.9% yield, but that was a “one time event”. If PFE trades at a 3% in 2017, there is an opportunity to make a 12% annualized return. If PFE ever returned to a 2.25% yield, the total return to today’s investor would be in excess of 100%.

Due to the “market plus” return opportunity, I am recommending a small weight in PFE, 1.5%. This is marginally higher than the benchmark weight of 1.32%.


Behavioral FinancePsychology has always impacted

markets (Mackay)Really got its start with Tversky

and KahnemanBecame popular in the late

1990s, when Michael Mauboussin, Terrence Odean, and Richard Thaler published a variety of works for the layman


Behavioral Finance

Who here is an above average driver?


Behavioral FinanceWho here is an above average driver?

Usually the answer is about 88%This question tested the heuristic of

“over confidence”; in the stock market, men are usually extremely

over confident, women less so; women tend to trade less because of that, and usually have better results…

“How much money would you have to win in order to bet $100 on a coin

toss?”


Behavioral Finance“How much money would have to win in order to bet $100 on a coin

toss?”The answer is usually about $200 or higher; the question tests risk aversion and decision timidity; of course, the theoretically correct

answer is $100 or $101 (neutral or positive expected return)


Behavioral FinanceWhich would you prefer?

Decision 1:A: Sure gain of $240B: A 25% chance to gain $1,000

Decision 2:C: A sure loss of $750D: A 75% chance to lose $1,000The original basis of Behavioral Finance was Prospect Theory, developed by Tversky and Kahneman. Sadly, Tversky never got a Nobel because the award is never given posthumously.


Behavioral FinanceIn Amos Tversky’s Studies:

Given a choice of A or B, 84% chose A

Given a choice of C or D, 87% chose D

Overall, 73% selected A&D

Only 3% selected B&C


Behavioral FinanceAggregating the choices, you see:

A&D = a 25% chance to gain $240, anda 75% chance of losing $760

B&C =a 25% chance to gain $250, anda 75% chance of losing 750

B&C are superior, but most people chose A&D; why does this happen?


Behavioral FinanceMost people are risk-averse when faced with a gain, but risk-seekers when faced with a loss. Basically, they are willing to pay a premium to obtain a sure gain, and to avoid a sure loss.

In combination, this leads to sub-optimal decision making


Behavioral FinanceOther types of questionsCollective problem solving;

consensus can be right; this was tested by having people guess the # of jelly beans in a jar (2,683). The guesses ranged from 98 to 10,000+ but the average of all guesses was 2,566. Only 2% of the guessers did better than the average…


Behavioral FinanceAnchoring

“What is your best guess about the height of the tallest redwood?”

#1 -“Is the height of the tallest redwood more or less than 1,200 feet?”

#2 -“Is the height of the tallest redwood more or less than 180 feet?”

Which question generates higher mean estimates?


Behavioral Finance“Is the height of the tallest redwood more or less than 1,200 feet?” 844’

“Is the height of the tallest redwood more or less than 180 feet?” 282’

Interestingly, 844-282=562; 562 divided by the difference in the anchors (1200-180) = 55% (the anchoring index); this is a typical ratio

The correct answer is around 379’


Behavioral Finance“A study of a Campbell’s soup sales promotion was conducted when the product was on sale for about 10% less than regular price. On some days a sign on the shelf said “Limit of 12 per person” and on other days the sign said, “No limit per person.” Shoppers purchased an average of 7 cans of soup when the limit was in effect, double the amount that they purchased with no limit.” - Anchoring Bias: The Power of Arbitrary Numbers (David Zuckerman, CFP®, CIMA®)


Behavioral FinanceAnchoring – or fixating on a number that may or may not be relevant – happens all the time in investing Investors like to buy stocks that have

declined a lot in price quickly, since they are focused on the old, high price

Mental Accounting in another heuristic. Investors allocated money mentally in their heads to different accounts or activities, even though money is fungible. Famous examples include the lost sandwich and the vacation account/high card debt.


Pot Odds

In a game of 5 Card Draw, with a four-flush OR an open ended straight draw, should you call a $10 bet with $50 in the pot?

Would you call a $20 bet with $50 in the pot on a four-flush AND an open ended straight draw?


Pot Odds

Yes, you’d call in either situation.

Outs (47 unseen cards) – Flush (38/9) = 4.22 to 1, Straight (39/8) = 4.88 to 1, Straight or Flush (32/15) = 2.13

Pots odds are 5:1 or 5:2, which are better than the odds AGAINST completing your hand


Other BiasesGambler’s Fallacy: a misunderstand of how random events are linked, or not linked

Often manifested in slot machine addicts, who don’t realize that each losing pull does not bring the jackpot one pull closer, since the events are not related (just like flipping a coin)

Herd Instinct/Mentality


Other BiasesConfirmation bias: “the confirmation bias suggests that an investor would be more likely to look for information that supports his or her original idea about an investment rather than seek out information that contradicts it. As a result, this bias can often result in faulty decision making because one-sided information tends to skew an investor's frame of reference, leaving them with an incomplete picture of the situation.” – investopedia.com


Other BiasesHindsight bias: “which tends to occur in situations where a person believes (after the fact) that the onset of some past event was predictable and completely obvious, whereas in fact, the event could not have been reasonably predicted.”– investopedia.comAlso applies to “selective

performance”


# of at-batsParticularly for aversion, it’s easy to make the wrong choices if you only get one try (take the $240); when you invest, you get many, many, many tries, so it’s important to train yourself to operate based on expected return, not (incorrect) instinct.

PFE & Behavioral Finance

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