Sunday, February 20, 2011

Merck and Pfizer: Thoughts on investing as a patriotic duty and market efficiency

We have an interesting long-term experiment in the making in the pharmaceutical business, as two of the largest players - Pfizer and Merck announced their plans for the future. Pfizer was the first up, announcing its plans to buy back stock and rein in R&D. Pfizer has been an active acquirer over the last few years, buying Wyeth for $68 billion in 2009, and this announcement seems to at least implicitly suggest at least a pause in, and perhaps an abandonment of,  that strategy.

Merck responded with a very different vision of its future, suggesting that it would be investing more in R&D and would not be returning cash (at least in the near term). Given that Merck spent $41 billion buying Schering Plough in 2009 and is still showing signs of indigestion from that acquisition, it is not clear whether this announcement is an indication that they have abandoned the "big acquisition" strategy for a return to basics.

The immediate reaction from the market was positive to Pfizer's announcement (an increase of 5-7% in the stock price) and negative to Merck's announcement (a drop of 2-5%). The reason these stories reverberate is because they also coincide with a push by the Obama administration to get US firms, which have been sitting on large cash balances, to do their patriotic duty and invest that cash, with R&D being singled out as a good place for the investment. So, here are some open questions:

1. Is investing in R&D and capital investments the patriotic thing to do?
Pushing companies to invest their cash, whether it be in R&D or in factories, is not always good for the economy and using patriotism as the argument for doing so strikes me as wrong on three levels.
  • The very fact that you have to use the patriotism card suggests to me that you have lost the economic argument. (It is akin to the "strategic" card that some managers pull when they want to push through an investment or acquisition that makes no economic sense.) Through the centuries, political leaders have called on their people to give up economic and political rights in the cause of the "greater good ". There are times where the argument reverberates. FDR and Churchill's pleas for shared sacrifice during the Second World War were responded to, because people (and by extension, corporations) recognized that losing the war would catastrophic to their own interests. And you cannot attribute the success to the persuasive powers of the leaders. After all, Winston Churchill lost his prime ministership and the British parliament in 1945, when the fear of war passed. In most periods, though, the argument falls flat because people detect the emptiness behind the sloganeering.
  • Is it patriotic for companies to build factories and invest in R&D, if the economic rationale for doing so is not there? Sure, if you define short term job creation as patriotic. After that initial glow, though, how do you sustain these uneconomic investments? You either provide taxpayer subsidies in perpetuity or the investments shut down: the former are not tenable with our budget deficits and with the latter, the layoffs return with a vengeance as the investment craters.
  • Even if you believe that it is appropriate to draw on patriotism as a rationale for economic decisions, it is one thing to ask it of individuals and another of corporations. A corporation is a legal entity, owned by stockholders. With globalization, the investors in many publicly traded US companies are Europeans, Asians and Latin Americans, just as investors in many companies in those countries are US citizens. Why should a Brazilian stockholder in Merck or Pfizer have to pay an economic price for either company to do its patriotic duty and invest in US jobs?
Bottom line: If you want to induce companies to invest their money, try to create an economic environment where such investments make sense. That does not mean creating special tax breaks for these investments (that is just another way of taxpayers subsidizing bad investments). It would imply reducing macroeconomic uncertainty and putting place policies that increase overall growth. If in spite of all these efforts, investments still don't make sufficient returns, the most patriotic thing for companies to do is to not invest the money but instead to give cash back to stockholders who will find better places to invest.

2. What does the market reaction to these announcements tell us?
I am always leery about reading too much into how the market reacts to individual firm announcements. After all, we have a sample of two in this case. But I can predict the two polar opposite reactions that the Merck/Pfizer news story will elicit.

At one extreme will be those who belong to the "don't trust markets because they are short term" group. To them, the fact that market reacted negatively to Merck, a firm belonging virtuously (any firm that invests in R&D is endowed with this label) and positively to Pfizer, a firm catering to the greediest among us (since only greedy investors want to cash out on investments) will be viewed as proof that markets are short term and not to be trusted. I would have more sympathy for their arguments if the market reaction was knee jerk, always negative for R&D (or other investment announcements) and always positive for stock buybacks. But that is not what the evidence indicates. On average, stock markets react positively to investment announcements, whether they be in R&D or more conventional capital expenditures, as evidenced by the figure below.

However, this chart is not a blanket endorsement of R&D or investment being good. In fact, stock prices go down at some firms that announce investment plans, as they did at Merck.

Is the market being unfair to Merck by reacting so negatively to the announcement that it would increase R&D? I don't think so and Merck's recent history is one reason that the market is skeptical. The firm has invested tens of billions in R&D over the last 20 years but they have not much commercial success to show for the investment. More significantly, they did spend $41 billion to buy Schering Plough just two years ago, an action that makes little sense if Merck felt confidence in their internal R&D's value creating ability. Finally, investors are also aware that the health care business is changing in fundamental ways and many of these changes will not be friendly to the bottom line at pharmaceutical companies.

At the other, there will be firm believers in market efficiency who will point to the market reaction as evidence of the foresight and wisdom of markets. I am not willing to go that far, based on the limited evidence. After all, there are investors who react to every stock buyback as good news, at least initially.

3. Which of these firms took the "right" action?
While the initial market reaction favors Pfizer, I think that it will take time to make the final judgment. I will be looking at three developments to draw my conclusions:

a. Market follow through: Investors get a chance to reassess their initial reaction as markets settle down and fundamentals reassert their dominance. If six months from now, Pfizer has been able to sustain its gains, I will feel more confident that it did the right thing to begin with. Conversely, if six months from now, Merck's stock price has reversed direction and risen, I will be less worried about the R&D being misspent.
b. Economic payoff: With Pfizer, I expect to see the "lesser" investment in R&D to be redirected to areas with higher payoff (and higher return on capital). With Merck, it would be too much to ask that their new R&D investment start paying off in the near term, but I would like to see some of the billions that they have spent on R&D in the last decade show up as blockbuster drugs in the pipeline. In other words, I am looking for evidence that Merck's decision to invest in R&D was based upon real promise that they were seeing in their labs and not just hope. (One item that makes feel a little better about Merck is that their pipeline is finally starting to show some promise)
c. Internal consistency: Perhaps, the worst thing that either firm can do now is take other actions that are inconsistent with their current actions, in terms of future direction. With Pfizer, these inconsistent actions would take the form of expensive acquisitions and new stock issues to fund these acquisitions, actions that don't jell with more frugal, mature, cash returning company it is portraying itself to be. With Merck too, a return to large acquisitions would contradict the return to R&D roots story that they are pushing.

Put succintly, as an investor, both firms are on probation, as far as I am concerned. Merck has a steeper hill to climb, because they are fighting their recent history and a health care business that has fundamentally changed, but Pfizer is not out of the woods either...


Mike said...

Prof, very thought provoking article. I appreciate it.

One comment...

...push by the Obama administration to get US firms, which have been sitting on large cash balances, to do their patriotic duty and invest that cash, with R&D being singled out as a good place for the investment

Does't this amount to encouraging Corporate malpractice?

While you are at it, if you have time, you might want to check this govt. (Fed) gameplan:

If possible, just read it and think about it. I won't ask you you comment on it.

Unknown said...

Respected Prof
Thanks for your reply. I am eagerly waiting for the research article which you are going to post. I have read sometime before about first hand insider information to top people,where the most retail investors are caught in after the run up of the stock. I request your comment and quote your and others research articles in this regard.

Mike said...

After reading Obama's advise to the US firms on where to invest, I am reminded of this classic:

The statesman who should attempt to direct private people in what manner they ought to employ their capitals would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it. -Adam Smith

Any comments?

Aswath Damodaran said...

I don't think Adam Smith needs me to rephrase his thoughts. He was centuries ahead of his time...

Unknown said...

Not sure if Obama's administration is singling out R&D as a good place to invest. In fact, they are doing the opposite - by proposing reduction in exclusivity


Aswath Damodaran said...

In fact, they are pushing in both directions. They want to reduce the exclusivity and potential profits from doing R&D, while getting firms to spend more on R&D. That should really work!

Mike said...

I can predict two scenarios in the pharma:
- The drug companies rise the price so that they can recover the cost faster.
- Big pharma companies will get waivers from the law. (remember the Health plan waiver)

Crane said...

Most of the important discoveries in large-molecule chemistry using the traditional methods have been made. There isn't much more to know about the pharma industry.

What is commonly referred to as biotech still has plenty of room to run, but returns there have never been as good as in large-molecule pharma because it is a more capital-intensive process.

Merck and Pfizer are priced like bonds at this point, with step-functions around legal events, product recalls or pre-clinical drug failures. We will see more blockbusters, but they will be few and far between and the infrastructure will have a hard time shrinking faster than the core revenue generating capabilities of the firm's in question.