It’s a question investors ask themselves every day: Should I seek safety in diversification by putting my money into a broad index fund, or should I aim for bigger returns by buying an individual stock knowing that one misstep by the company could tank the entire investment?
The usual answer is, it depends. Namely, it depends on a variety of factors ranging from current stock valuations to the economic and regulatory environment to a particular company’s prospects, just to name a few potential variables worth considering.
With that as the backdrop, fans of blue-chip stocks are feeling especially vexed about balancing risk and reward right now. The Dow Jones Industrial Average (DJINDICES:^DJI) is going strong despite recent turbulence, but it still feels overbought. The Dow’s worst performer of the past 12 months, on the other hand, looks like it may never stop falling, yet the pullback has improved the value-based bullish argument for investing in it. That lousy performer, by the way, is biopharma outfit Amgen (NASDAQ:AMGN). Its stock price is down more than 11% since this time last year and has lagged the Dow’s other 29 names during most of that time.
For most investors looking to put some idle cash to work right now, the better overall bet here would be to buy shares of Amgen rather than a blue-chip index-based fund like the SPDR Dow Jones Industrial Average ETF (NYSEMKT:DIA).
Why not the Dow?
Don’t misread the message. Most investors would still be well served by sticking with indexes most of the time. Matters are a bit out of the ordinary right now, however.
Chief among the oddities impacting this situation is the scope of the broad market’s run-up since March of last year. The Dow’s gain since then has been more than 90%, which is tremendous, but not easily sustainable. If there’s nothing else to be gleaned from the Dow’s sizable dip since last month’s peak, we can reasonably assume that at least some investors are ready to lock in some profits. The more selling those traders do, the more the market dips, which inspires even more price-pressuring profit-taking, etc.
Then there’s the not-so-small matter of valuation. The Dow Jones Industrial Average is now priced at 23.6 times its trailing 12-month earnings, according to data from Birinyi Associates, while the S&P 500 (SNPINDEX:^GSPC) is currently trading at a trailing P/E of 31.2. Both of those metrics are above long-term norms.
Most students of the market will recognize that the past 12 months have still been riddled with pandemic-related problems, just as they will be aware that the forward price/earnings ratios for the Dow and S&P 500 stand at more palatable levels of 18.8 and 21.9, respectively. Those outlooks may be unduly optimistic, however, given what most investors probably don’t know about the current condition of the market.
Did you know that while the lingering impact of COVID-19 has crimped corporate revenue of late, profit margins have never been stronger? The S&P 500’s average operating profit margin — the percentage of revenue converted into earnings — for the past 12 months is just a hair under 12%. Typically, the average profit margin sits within the 9% to 11% range.
Surprised given the challenging circumstances? You’re not alone. More relevant right now, though, is the distinct possibility that analysts are basing their forward-looking earnings estimates on profit margin rates that aren’t sustainable. If and when they start to realize that — for example, if disappointing quarterly results start to pour in — that will work against valuations in the broad market.
It’s difficult to pinpoint exactly why Amgen stock has been such a poor performer of late, but we can ultimately blame the coronavirus. Not only did the pandemic lead many people to avoid seeking medical care in situations where they might normally have done so, it has also stymied some of Amgen’s drug trials. And while the company did help Eli Lilly manufacture its COVID-19 drugs, Amgen was never a contender in its own right in the efforts to develop vaccines or treatments for the coronavirus.
Thus, it fell out of favor on Wall Street as investors flocked to biopharma names that were positioning themselves to capitalize on the new opportunity at hand.
The thing is, nothing has really changed about Amgen’s long-term growth prospects. This is still the same company that makes Enbrel, bone-strengthening Prolia, and Otezla — for psoriasis — just to name a few of its drugs. It’s also still the same company that has yet to tap the full revenue potential of cancer-fighting Kyprolis, high-cholesterol drug Repatha, and Neulasta, which helps cancer patients recover from some of the fallout of using cancer medications. All told, Amgen has 20 revenue-generating drugs in its portfolio, not one of which accounts for more than 20% of the company’s consistently growing top line, and only two of which account for more than 10%.
Amgen is missing out on the revenue opportunities resulting from COVID-19. The need for those vaccines and treatments will eventually peak, though, after which the biopharma industry will ease back to normal. Amgen is ready for that time even if its current stock price suggests investors aren’t as interested in those longer-lived opportunities, or the pipeline of treatment candidates that will plug the company into them.
New investors can step into Amgen while its shares are priced at a mere 12 times next year’s projected profits. Better yet, the dividend yield is a healthy 3.3%, so those shareholders will get paid reasonably well while they wait.
It really is about balancing risk and reward
A year ago, this wasn’t the case. A year from now, it may not be the case. Amgen could rally to uncomfortably rich valuations by the third quarter of 2022, and the Dow Jones Industrial Average may well peel back to prices that more accurately reflect the profit-margin contraction that’s apt to be in the cards. Balancing risks and rewards is a dynamic, ever-changing dance.
However, it’s not a dance that investors should sit out by pretending that valuations and misreads of the marketplace don’t matter.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.