Playing Torpedoed Stocks

A post-mortem on McKesson and Diplomat Pharmacy:

I recently read an analyst report from UBS that recommended an overweight position in the healthcare sector. I agree with the report in that the healthcare sector represents far better value than it has in recent history. Only during the financial crises were healthcare stocks cheaper. For most of the past 20 years, the sector has been on a tear with some very infrequent corrections. Starting last December, led by biotech and big pharma, the sector began a streak of under-performance that continues to this day. The political and regulatory winds are changing direction rapidly. That said, some other analysts believe the sector has discounted any bad news on the horizon. People seem resolved to the fact that margins may compress and profits may suffer a bit but they add, this is already priced into the market. While this may be the correct line of thinking, I believe stockholders in McKesson and Diplomat would beg to differ.

McKesson is one of the three major pharmaceutical distributors (AmerisourceBergen and Cardinal are the other two). The three, combined, control 95% of the market. McKesson is a blue chip stock with a long and successful operating history. But their recent earnings and revenue announcement was greeted with near panic selling in the market. McKesson (MCK) used to be a $240 stock a little more than a year ago. It sharply corrected to the $150-$170 area and had some minor rallies. Then last week’s bombshell caused another wave of substantial selling by institutions and fund managers. The stock dropped from $165 to $125 in one trading session—25% of its market cap wiped out in 6 hours. In short, this industry leader has seen its price discounted by 40% in 14 months.

A few days later, Diplomat Pharmacy (DPLO), a specialty pharmacy company, got torpedoed as it missed earnings, as well and gave investors an extra kick in the shins by guiding lower for 2017. The stock was trading at around $22 a share before the announcement. Apparently, they were adversely affected by lower Hep C sales (we should have seen this coming with Gilead’s stock price drop – Gilead has huge exposure to Hep C drug sales with Sovaldi being their blockbuster drug for hepatitis C) and direct/indirect remunerations to Medicare. Investors certainly didn’t like management’s outlook because DPLO got slaughtered in a viscous decline from $22/share to $13/share in one trading day—a loss of 41% in the session. Longer term, DPLO has fallen from just over $50 a share to $13 a share.

What can we learn from the markets violent reaction? While healthcare might be undervalued relative to the S&P 500, investors are still suffering from major anxiety. Even a hint of underperformance or negative guidance brings swift and painful punishment! Declines of this magnitude in one trading day tell me a few things:

  • There are likely more landmines out there. Whatever is influencing the results at MCK and DPLO is certainly spilling over into other companies. Control your risk and use some risk management.
  • In many cases, declines like this constitute major buying opportunities… at least in the case of McKesson. Less so with Diplomat, as their operating history is much shorter and they recently went public.
  • Be careful what you read out there. Overall, healthcare may be undervalued, but as these two stocks indicate, they can always become more undervalued.

In summary, both McKesson and Diplomat were on watch-lists for consideration to purchase should they decline. Diplomat will require some due diligence and further research to see if this misfortune is temporary in nature or something more serious. McKesson should have greater visibility, especially after we see how the political landscape looks after Tuesday’s elections. Until then, be particularly careful out there!!

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