As I’ve studied the market over the years, one of the intriguing contrasts comes in the way different analysis methods take in the “big picture” of the market. That includes the way that fundamental investors and analysts look at the market versus those that prefer to work on strictly technical terms. I like to work with a blend of both methods, which means that sometimes I have to find ways to resolve contradictions between the two.
Here’s one of the most basic examples of what I mean. One of the core principles of fundamental analysis holds that stock prices are a reflection of the strength in the underlying business; increasing profits should logically translate to higher stock prices. Technicians, on the other hand prefer to think of the market as a reflection of investor sentiment, which can of course be influenced by fundamental strength in a stock’s underlying business, but is also subject to any number of other factors that can swing an investor’s view of a stock’s opportunity or risk. Sometimes those disparate views converge, which means that fundamental strength will coincide with a nice increase in stock price, or that fundamental weakness will line up with an extended decline in price. Which one was more right, or possibly influenced the other? I think that’s a bit like asking which came first, the chicken, or the egg; you can circle around one or the other forever and never really come up with a satisfying answer.
I’m bringing up this conundrum because sometimes, the market just doesn’t make sense. Watching news headlines this past weekend didn’t seem to offer much that would give the market positive momentum; but through the first three days of the week, the S&P 500 has rallied more than 9% higher. On the back of a strong move off of March 23 lows around 2,200, that means the index has rallied about 18% higher in the last two weeks. That’s a strong enough move that you might think that a breakthrough has been found in the battle against COVID-19, or that at least the rate of infection has slowed enough to allow life, and business to start to resume some sense of normalcy. Not so fast; most scientific experts aren’t expecting the virus to reach peak infection rates in the U.S. until later this month; over the weekend, in fact, President Trump warned that the next week to two weeks will see an even more alarming increase in the fatality rate, and that things are likely to get even harder than they are before they get better.
Not being able to pin the market’s rally on something substantial means that I’m a little hesitant to get very excited about the likelihood the bullish momentum is going to hold. It also means that I still think the smart approach right now is to be very cautious about taking on new positions; when you do, focus on stocks in defensive industries. I still like Food Products in that context, but I also think that healthcare is a smart place to be right now – especially if you’re paying attention to some of the biggest and most established names in that space. Why? Many of these companies are shifting major resources into fast-tracking COVID-19 treatments and vaccines, or the equipment and supplies that are being strained by the virus, but are critically necessary for medical professionals to treat patients – of all types, not just COVID-19-affected – safely. Others, like Merck & Co. (MRK) may not be in the middle of that battle in the same way, but are nonetheless providing critical resources in other areas that are just as important.
MRK is one of the largest companies in the Pharmaceutical space, with a big pipeline of drug treatments, and patent protection that offers a shield from revenue erosion for most of its biggest revenue producers. That’s a big deal, because once a patent on a proprietary drug expires, generic producers can start using the same formulas to offer lower-cost alternatives. Patent protection means that MRK is assured of pricing protection on important drugs like Keytruda, a cancer drug that the company is working hard to expand as a treatment solution for a widening scope of cancer types. In the case of Keytruda, that patent extends into 2028. MRK can say the same thing about the patents on all of its key brands; the earliest expiration of its patent exclusivity on any of the big drivers comes in 2022. The stock has rallied with a lot of other names in the industry over the last two weeks, rising nearly 21% from a low right around the market’s bottom on March 23. Does that make the stock a good buy right now? Let’s dive in.
Fundamental and Value Profile
Merck & Co., Inc. is a global healthcare company. The Company offers health solutions through its prescription medicines, vaccines, biologic therapies and animal health products. It operates through four segments: Pharmaceutical, Animal Health, Healthcare Services and Alliances. The Company’s Pharmaceutical segment includes human health pharmaceutical and vaccine products marketed either directly by the Company or through joint ventures. Human health pharmaceutical products consist of therapeutic and preventive agents, generally sold by prescription, for the treatment of human disorders. The Company sells its human health pharmaceutical products primarily to drug wholesalers and retailers, hospitals, government agencies and managed healthcare providers, such as health maintenance organizations, pharmacy benefit managers and other institutions. Vaccine products consist of preventive pediatric, adolescent and adult vaccines, primarily administered at physician offices. MRK’s current market cap is about $199 billion.
Earnings and Sales Growth: Over the last twelve months, earnings and sales have increased, with earnings increasing a little over 11.5%, and sales growing about 8%. In the last quarter, earnings declined about 23% while revenues dropped a little more than -4.2%. MRK’s profit margin is healthy, but narrowing slightly. In the last twelve months, Net Income as a percentage of Revenues was 21% and 19.8% in the last quarter.
Free Cash Flow: MRK’s free cash flow is healthy, at $9.96 billion over the last year. This number has increased since the last quarter of 2017, which Free Cash Flow was a little over $4.5 billion. Its current number translates to a modest Free Cash Flow Yield of 5%.
Debt to Equity: MRK has a debt/equity ratio of .87. This is a generally conservative number, which is supported by the company’s balance sheet, which indicates operating profits are sufficient to service the debt they have. They also have good liquidity, with $10.45 billion in cash and liquid assets versus $22.7 billion in long-term debt.
Dividend: MRK pays an annual dividend of $2.44 per share, which translates to an annual yield that of about 3.11% at the stock’s current price.
Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but I like to work with a combination of Price/Book and Price/Cash Flow analysis. Together, these measurements provide a long-term, fair value target around $64 per share. That means the stock is clearly overvalued, with -19% downside from its current price.
Technical Profile
Here’s a look at the stock’s latest technical chart.
Current Price Action/Trends and Pivots: The chart above displays MRK’s price action over the last two years. The red diagonal line plots the stock’s long-term upward trend through 2019, and also provides the baseline for the Fibonacci retracement lines on the right side of the chart. The stock’s drop this year pushed it below the 61.8% Fibonacci retracement line in late March. From that point, the stock has rallied strongly, pushing this week above 38.2% retracement line at around $78.50. That should now act as immediate support, with secondary support likely anywhere between $73 and $75 (the 50% retracement line is around $74, and provides a pretty good visual queue in that case). Nearest resistance right now is around $84 based previous pivot highs in 2019, with room to move to about $87 if bullish momentum stays strong in the near term.
Near-term Keys: While I can’t call MRK a good bargain right now, the fundamentals are very strong, and there it looks like there is a lot of institutional money rotating into the Pharmaceutical sector and into stocks like MRK, which means that near-term momentum is strongly on the bullish side. If you like working with short-term trading strategies, the recent push above $78.50 is a good signal to buy the stock or to consider working with call options, with an eye on a bullish profit target between $84 and $87. A push below $78.50, on the other hand could offer an interesting opportunity to consider shorting the stock or working with put options, with $74 as a useful profit target for a bearish trade.