Seeking Market-Beating Returns: GlaxoSmithKline plc Stands Out

GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US), British American Tobacco (LSE: BATS), Next (LSE: NXT) and Royal Mail (LSE: RMG) offer a return on equity higher than 40%, based on their trailing figures. A different risk profile is associated to each business — but GSK stands out.

GlaxoSmithKline Leads The Pack

After a long chat with a friend in the City who has been a pharma analyst for ages and knows the industry inside out, I wondered: what would I not like about GSK if I were to bet on a pharma company today?

GlaxoSmithKlineGSK is a cash machine with a strong market share in the industry. The stock is flat for the year; it’s down 5% in the last 12 months; and it’s up only 10% in the last two years. There is more to it.

“GSK doesn’t have that big a patent cliff to speak of – certainly nowhere near as big as the likes of AstraZeneca or Eli Lilly & Co.,” my friend pointed out.

With regard to the latest round of bad publicity, i.e. the recent scandal in China, he noted: “(GSK is) not affected at all. This is a good scandal story for mainstream press, but the investment community basically sees this as the ‘cost of doing business’ in places like China.”

And what about GSK’s latest corporate activity?

“Well, oncology is the number one area for R&D today. Full stop. And through the Novartis deal, GSK seems to be signalling that it’s getting out of it. True, its products will probably sit better at Novartis, which has a bigger presence (…),” he started.

“I’d suggest that internally GSK in fact has no intention at all of getting out of oncology – it would be mad to – and will instead do more licensing in now to bolster its pipeline,” he concluded.

If anybody thinks AstraZeneca’s valuation is justified, then GSK should trade a lot higher, we both agreed.

GSK could be bought for tax reasons, “though even Pfizer doesn’t need a takeover as big as this to do an inversion,” he reminded me. Of course, GSK stock doesn’t price in an M&A premium, but a takeover of GSK is very unlikely.

Finally, GSK’s capital structure is much more efficient than that of other rivals.

British American Tobacco, Next and Royal Mail

At a time the stock market trades at all-time highs, BAT is certainly a defensive stock to hold as part of a diversified portfolio. Its revenue growth trajectory is not terrific, but its operating margin and free-cash-flow yield are truly impressive. BAT’s balance sheet can be levered up, which leaves plenty of room for shareholder-friendly activity. The tobacco industry may be a play on consolidation, which could also help boost the value of several players in the industry.

Elsewhere, most retailers have been hammered in recent weeks. Next is holding up relatively well and, it must be noted, has been a takeover target for some time. Bullish estimates for top-line growth into 2017 are reasonable; operating profitability is in the region of 19% and is growing fast; its bottom line has expanded for years, and earnings per share are expected to grow in future; and its balance sheet is healthy.

Of all, Royal Mail is the less compelling investment case as it’ll need to prove that it can remain profitable without losing competitiveness in the UK. And that is certainly not a given…

Elsewhere, there are much smaller companies that could beat the market these days. In the last five years, this stock has performed +637%, and could offer even more upside over the medium term.

In spite of an incredible rally, its trading multiples are not too demanding and more upside could also come from a takeover of this British high-tech business.

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Alessandro does not own shares in any of the companies mentioned. The Motley Fool has recommended shares in GlaxoSmithKline.