One thing that many investors become fixated on is always wanting the next ‘hot tip’ or the ‘inside word.’ Forever seeking an edge on everyone else, investors seek the holy grail of critical company knowledge that will allow them to score that big profit.
What about if we considered the following? Instead of trying to figure out which is the most undervalued company; we focus on how we can best apply a bullish view on a company? We ask ourselves, how can we apply a bullish view that is linear in its downside and non-linear in its upside?
What I mean by this is how we apply a view that if we are wrong we lose $1 but if we are right we stand to make considerably more than $1? Or put another way – how we have leverage on the gains but not the losses?
I believe we can achieve this ‘linear loss / non-linear win’ payoff profile using long dated call options on stocks with relatively low volatility. I have shortlisted 3 stocks in the pharmaceutical industry that I believe have good long term prospects and still the capacity to surprise on the upside.
Merck & Co., Inc. (NYSE:MRK)
A big player in the pharmaceutical world, Merck is a powerhouse when it comes to producing drugs that sell by the millions.
What I like about Merck’s prospects is their CEO’s attitude to investing in drugs that have the potential to be ‘real game changers.’ I recently came across an interview with CEO Kenneth Frazier. He was questioned about the viability of Merck & Co., Inc. (NYSE:MRK) investing heavily into R&D for Alzheimer’s drug research. Frazier responded with saying, ‘Isn’t that exactly what the world wants a company like Merck to do?’
As an investor, this is the attitude I like to see from a CEO – a willingness to back his team to invest in projects that have the potential to produce enormous, outsized profits.
Merck & Co., Inc. (NYSE:MRK) may well spend tens of millions in R&D for a successful Alzheimer’s drug. A successful drug will likely mean many billions of dollars in additional revenue.
Pfizer Inc. (NYSE:PFE)
Pfizer is a giant in the pharmaceutical world with a market cap of over $200 Billion. Pfizer Inc. (NYSE:PFE) is currently trending quite nicely, Yet still conservatively valued. With a Forward P/E of less than 12 and a dividend yield of over 3%, Pfizer is by no means overvalued.
Pfizer has until recently faced the headwind of Lipitor coming out of patent. However Pfizer seems to be showing it can survive and improve even as flagship products like Lipitor patents expire.
With 17 molecules in Phase III Trials, to me Pfizer only needs to have a success rate of 2 out of 10, and all of a sudden 3 drugs are approved and in a position to generate substantial revenue.
With such win-loss payoff profiles, Pfizer Inc. (NYSE:PFE) can the majority of the time be an abysmal failure yet the 2 or 3 successes are more than enough to produce healthy profits.
Eli Lilly & Co. (NYSE:LLY)
Eli Lily offers virtually the same potential as Pfizer. With 13 drugs in Phase III trial stages, the odds of a huge, successful blockbuster can afford to be low and still a success.
Eli Lily has shown that it is resilient in the face of a ‘patent cliff’ by continuing to perform well even as a number of patents expired in 2011/12.
With the world seemingly becoming more unhealthy as each year passes, all three companies are positioned to profit handsomely. With the nature of the industry a breakthrough product can produce enormous profits.
Applying a view
Having discussed the prospects of these three companies and why I am bullish on them, my attention now turns to how can I best apply the bullish view.
Long term calls on Merck, Pfizer Inc. (NYSE:PFE) and Eli Lily are all trading at levels of volatility that is quite low.
January 2015 at the money calls are trading at a premium equal to approximately 8-10% of the share price.
To me, paying 8% for an at the money call on a stock with 22 months until expiration is a very low risk proposition. Especially when the underlying companies have the capacity to produce unexpected and outsized profits.
The nature of the industry is freakish large profits can occur, paying 8% for two years of upside exposure to this to me fits the criteria of linear loss / non-linear win profile.
The article There Is Big Money in Drugs.. Legal Ones! originally appeared on Fool.com and is written by Jarrod Bailey.
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