Merck’s Value Proposition Could Prove Dangerous

Analysts and fund managers are quick to point out that recently decimated shares of pharma giant Merck (MRK) present value to investors; with an unusually high dividend ($1.52 annually for a yield of more than 5%), a below-market earnings multiple, and a stock price not seen in about a decade. Merck CEO Ray Gilmartin has remained adamant that the dividend is safe and will not be cut, despite 2005 earnings per share estimates having been slashed from $3.40 to $2.60 since the withdrawal of Vioxx.

With $2.5 billion in annual Vioxx sales now gone, investors are focused on thousands of class action lawsuits which are sure to surface shortly. Settling all claims could cost the company billions of dollars. Another blockbuster drug, Zocor, which amounts to $5 billion of Merck’s $22 billion in revenue, is set to come off patent in 2006. So, in a span of less than 2 years, Merck will have lost $7.5 billion in sales, or about a third of its business, all while attempting to defeat thousands of lawsuits from patients who have taken Vioxx for years.

It appears possible that concrete evidence will surface that could prove Merck management knew of the increased heart attack risk that Vioxx presented, but chose to keep it in close confidence. Although not a probable result, it is not out of the question that this company could be in trouble if such a scenario played out. With its base business set to deteriorate, the longevity of a large dividend payout certainly comes into question. As does the “value” presented by Merck shares with a 2005 P/E of 11, when it could prove very tough to hit the reduced EPS estimates of $2.60 per share.

Investors should not assume the 5-plus percent dividend makes the stock a safe value play, even if the CEO insists it will not be cut. Shorting the shares is costly as long as the dividend remains, as those who borrow the shares will have to pay whoever bought their shares. As a result, the best way to play a further fall in Merck shares, if you are wary of the company’s future prospects, may be owning in-the-money puts.

Do Elections Affect the Stock Market?

The last of the three presidential debates for 2004 concluded last evening. We’ve heard plenty of election coverage, so I won’t get into much of the politics here, but one question is relevant to me and my clients. Will next month’s election (or any presidential election for that matter) affect the stock market’s future returns. And if so, how?

Much of the country has concluded during President Bush’s first term that his policy of reducing taxes on income, capital gains, and dividends has helped bring investors back to the market after many portfolios were dismantled in the first three years of the new millennium. Some have worried that the market would react negatively to a Kerry victory in November due to his desire to raise taxes for those individuals earning more than $200,000 a year.

We have also heard that academics have found that the market itself performs better under Democratic Presidents, as opposed to Republican ones. Interesting contradiction, isn’t it? Rather than listen to the pundits on television, I decided to take a look at the research myself and determine which, if any, political side is better for the stock market. Stock prices are proven to follow corporate earnings over the long term, and most won’t argue that the best predicter of company profits is economic growth. Here is what I found.

There are two sets of numbers highlighted below. The first are the most commonly used economic statistics used to measure the health of the economy; GDP growth, unemployment, inflation, growth in federal spending, the budget deficit, and the national debt. These numbers came from research completed by the Bureau of Labor Statistics (BLS) and the Bureau of Economic Analysis (BEA), both non-partisan bodies that the White House and others rely on for unbiased data continually. This data is for the 40-year period from 1962 through 2001. The results are very interesting, especially if you favor the Republican political view that seeks to lower taxes and reduce government spending, as opposed to the “perceived” idea that Democrats prefer to “tax and spend.”

From 1962-2001:

GDP Growth: 3.9% (D) 2.9% (R)

Unemployment Rate: 5.1% (D) 6.8% (R)

Inflation Rate: 4.3% (D) 5.0% (R)

Growth in Federal Spending: 7.0% (D) 7.6% (R)

Growth in Federal Spending (Ex-Defense): 8.3% (D) 10.1% (R)

Yearly Budget Deficit: $36 Billion (D) $190 Billion (R)

Total Increase in the National Debt: $720 Billion (D) $3.8 Trillion (R)

(Sources: BLS & BEA)

The first point to make is that while Republicans are billed are fiscally conservative and tax reducers, over the last forty years Democratic Presidents have actually spent less and been much better balancing the U.S. budget. And while Republicans have taxed Americans less, that has not translated into better economic prosperity, as measures of inflation, GDP growth, and unemployment all have been better under Democratic leaders.

Now, that’s fine, but the real question is how this relates to stock market performance. Despite what the economic numbers above reflect, what happens to stock prices while each party is in office should be the real question. If Republicans are indeed better for the markets, then you can argue that even though favorable economic statistics sound good, they won’t really help grow your investment portfolio. Not surprisingly, though, the stock market did prefer better economic conditions, as you can see below.

Avg S&P 500 Returns: Democratic Presidents vs Republican Presidents

1926-1997: 15.1% (D) 10.7% (R)

(Source: Stock Traders Almanac)

For some, these statistics will be important when you go out and vote for our next President on November 2nd. For others, they won’t be. However, as a money manager I was curious to see if the claims made frequently in the media are actually true, so I thought I’d share my findings.