Many investors who focus on a low price-to-earnings (P/E) ratio and high dividend yield in their search for value will have a hard time swallowing the maxim legendary investor Warren Buffett lives by: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.
Today, I’m considering whether FTSE 100 pharmaceuticals giant GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US) is a ‘wonderful’ company, and whether its shares are trading at a ‘fair’ price.
A wonderful company?
Buffett’s investment company, Berkshire Hathaway (NYSE: BRK-B.US), actually has a small stake in GlaxoSmithKline — first disclosed during February 2008. Interestingly, Berkshire invested at a time when GSK’s chief executive, Jean-Pierre Garnier, was retiring and being replaced by Andrew Witty.
Buffett is well known for his admiration of long-tenured managers with a passion and commitment to their companies. While Witty was new to the chief executive role, he’d been with GSK since 1985, gaining extensive experience across the business, latterly as president of GSK Europe. Witty is now in his sixth year as chief executive, and at just 49 years old could have a long tenure ahead.
If Witty fits the character profile of a Buffett manager, the numbers he’s producing at GSK also stack up. Buffett is dismissive of companies trumpeting “record earnings per share”. He says: “We believe a more appropriate measure of managerial economic performance to be return on equity capital”.
Wonderful companies deliver a high return on equity (ROE). Let’s pitch GSK’s percentage ROE over the period of Witty’s tenure against that of the UK’s no. 2 drugs company, AstraZeneca, which Berkshire doesn’t hold.
| Company | 2008 | 2009 | 2010 | 2011 | 2012 | Average |
|---|---|---|---|---|---|---|
| GlaxoSmithKline | 43.2 | 39.5 | 23.3 | 38.4 | 42.8 | 37.4 |
| AstraZeneca | 33.9 | 31.9 | 31.9 | 34.2 | 25.6 | 31.5 |
Source: Morningstar
Now, GSK’s ROE has been enhanced by higher borrowings than AstraZeneca, but it’s actually made sense for strong companies to borrow at the attractive rates on offer in recent years. Buffett doesn’t mind a manageable level of debt, and GSK’s interest cover ratio on its borrowings is a healthy 10.
A fair price?
Berkshire actually trimmed its stake in GSK by a small amount during the second quarter of this year. I can’t tell you the price the sale was made at, but GSK’s average closing price during the period was 1,655p (low 1,517p; high 1,778p). GSK’s current share price is 1,603p, so within a range where Berkshire has sold a few shares, held the vast majority, but not been tempted to buy more.