A key reason for the FTSE 100’s disappointing performance versus other major indices is the lack of share price growth from some of its biggest constituents. This is crucial in a market-weighted index, where the bigger the company the more significant its impact on the index price level.
One example of such a stock is GlaxoSmithKline (LSE: GSK). It is currently the sixth biggest company by market capitalisation in the index and its price has fallen by 9% in the last year, thereby dragging the wider FTSE 100 down. And, with its performance in prior years also having been poor…
A key reason for the FTSE 100‘s disappointing performance versus other major indices is the lack of share price growth from some of its biggest constituents. This is crucial in a market-weighted index, where the bigger the company the more significant its impact on the index price level.
One example of such a stock is GlaxoSmithKline (LSE: GSK). It is currently the sixth biggest company by market capitalisation in the index and its price has fallen by 9% in the last year, thereby dragging the wider FTSE 100 down. And, with its performance in prior years also having been poor and heavily affected by bribery allegations and generic competition on key products, many investors will understandably be feeling rather downbeat regarding its future prospects.
However, GlaxoSmithKline could realistically rise to £20 over the medium to long term. That would equate to a capital gain of 48% from its current price of £13.50 and a key reason for this is its dividend appeal. With the Bank of England being at pains to point out that interest rate rises will be slow, steady and may not start until more than halfway through next year, GlaxoSmithKline’s 6%+ yield has high appeal.
In fact, with the market being of the view that the base rate will stand at just 1.3% by the end of 2018, 6%+ yields are likely to command huge demand in future years. And, if GlaxoSmithKline were to trade at £20, its yield would fall to 4%, which is in-line with the yield of the wider index.
Furthermore, with the uncertainty that the world currently faces (both politically and economically), more stable and resilient stocks such as GlaxoSmithKline could become en vogue. That’s especially the case since the pharmaceutical sector is less positively correlated with the performance of the wider economy and so can provide higher returns during less favourable periods for cyclical stocks.
In addition, GlaxoSmithKline has an excellent pipeline of new drugs which are likely to propel its earnings higher in future years. For example, its ViiV Healthcare divisions is among its most exciting prospects and this should be an engine of growth for the business, while cost cutting and efficiencies are also set to make a positive impact on the company’s bottom line.
Evidence of their impact can be seen in 2016’s forecast earnings numbers, with GlaxoSmithKline expected to increase its bottom line by 11%. And, looking further ahead, the potent mix of a strong pipeline of new treatments and improved efficiencies could lead to a similar rate of growth in future years.
Despite this positive growth outlook, the company’s shares trade on a price to earnings (P/E) ratio of just 15.9. For a pharmaceutical major, this appears to be rather low and GlaxoSmithKline could easily demand a P/E ratio of over 17, particularly when its upbeat prospects are taken into account. This rating, plus three years of 11% earnings growth, would be sufficient to push the company’s share price to above £20, thereby providing its investors with a healthy return.
Clearly, GlaxoSmithKline is not without risk and, as with all pharmaceutical companies, pipelines can fail to yield the expected results. However, GlaxoSmithKline’s risk/reward ratio is highly enticing and, while it has disappointed in the past, its future performance looks set to make a positive contribution to the FTSE 100.
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Peter Stephens owns shares of GlaxoSmithKline. The Motley Fool UK has recommended GlaxoSmithKline. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.