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What We Can Learn From Catastrophes

What We Can Learn From Catastrophes

In the last few weeks we’ve discussed two companies who have been embroiled in scandals this year: Wells Fargo and Samsung.

Samsung, with its exploding Galaxy Note 7 phones, has lost billions in market value, has cut its operating profit projection by $2.3 billion, and won’t have a high-end mobile phone competing against Apple’s iPhone and Google’s Pixel going into the holiday season, costing it customers in the near-term, and presumably well into 2017.

And then there’s Wells Fargo. The bank has been reeling since news broke that employees had created millions of fraudulent customer accounts over the last five years in a scheme to collect fees and meet sales targets.

It seems impossible to avoid seeing new stories about both companies released on major news outlets daily. And the news keeps getting worse for both.

Both of these companies are clearly in crisis mode, but neither, comparatively speaking, are experiencing a complete catastrophe.

On a 10-point scale measuring the reputational and financial damage a crisis does to a company, Srinivas Reddy, director of the Center for Marketing Excellence at Singapore Management University who researches product and brand failures, ranked Samsung’s Note 7 recall between a 4 and a 7, making it far from the worst recall in history.

By comparison, he rates Merck & Co.’s 2004 scandal with its drug Vioxx at a 10. The recall was a catastrophic disaster with payouts from lawsuits and government investigations totaling roughly $8.5 billion in the 12 years since the recall.

But Merck’s disaster can teach us something.

If you’re familiar with Sir John Templeton, you’ve likely read this quote before:

Invest at the point of maximum pessimism.

When sentiment is at its lowest point—whether for an individual stock, or for a sector or the broader market—it creates the perfect time to buy. It’s the basic investing principle of buying low and selling high.

But this nugget of wisdom is lost on many investors. Average investors make their decisions based on news and the opinions of analysts rather than doing their own research.

But if you want to be better than the average investor and attain incredible returns, you have to find value in what the crowd has left for dead.

In the case of Merck, the voluntary recall of its “super aspirin” drug Vioxx not only left an $8.5 billion hole after lawsuits and investigations were settled, it also effectively destroyed the company’s public reputation.

Vioxx was approved by the FDA in 1999 as an anti-inflammatory pain killer. It was broadly prescribed for arthritis-related ailments and accounted for $2.55 billion in sales in 2003.

Merck recalled the drug suddenly in 2004 after discovering that a top medical journal was going to be publishing a study by an FDA investigator indicating that Vioxx greatly increased the risk of strokes and fatal heart attacks, and was likely responsible for the deaths of at least 55,000 patients in the U.S. in the five years it had been on the market.

The company claimed that it was being proactive in recalling the drug, and that it did so to protect patients. But it quickly turned out that Merck had known about the potentially deadly side effects of Vioxx even before launching the drug in 1999. The company had hidden these side effects, brushing the tests documenting the disturbing effects under the rug.

Vioxx had had an average TV advertising budget of $100 million per year, and had very quickly become one of Merck’s best-selling drugs. Nearly 25 million patients had been prescribed the aspirin substitute thought to have fewer complications by the time it was recalled.

Immediately upon the announcement of Merck’s voluntary recall of the drug, the company faced thousands of lawsuits, and nearly two-dozen personal injury lawsuits. One such lawsuit, a class-action suit, dragged the company through court for years, eventually settling for $4.85 billion in 2007. Ultimately, Vioxx was still profitable as it raked-in $10 billion in its time on the market, and only $8.5 billion was paid-out to settle in the aftermath.

Of course, when the Vioxx scandal first broke in late September 2004, Merck’s stock tanked -40%. However, from that low of $26, the share price rose to as high at $61 over the next several years indicating the $26 price had been a point of maximum pessimism and a great buying opportunity for bold investors.

After reaching new highs in 2008, Merck crashed with everything else during the financial crisis, when most of the entire market had hit a point of maximum pessimism. Interestingly though, Merck’s share price didn’t drop much below that 2004 low of $26 per share.

If we fast-forward to today, Merck’s stock looks as strong as a racehorse and both the late 2004 Vioxx scandal low and the 2009 subprime bottom proved to be points of maximum pessimism and great buying opportunities.


Source: TradingView.

The drug maker has been in an uptrend since this past spring, and had a one-day 10% moonshot in early August. It has gained just over 200% since its lowest point in 2009, and has gained 19 percent this year alone. The stock price appears to be consolidating in a sideways trading range before possibly breaking out to the upside.

Just last week, Bank of America even upgraded the stock from a Neutral to a Buy, with a targeted rise to $70. If Bank of America’s projection is correct, which I believe it is, there’s a conservative 12% upside.

That near-term potential gain aside, in the long run Merck has a lot of potential. While it’s still settling the remaining lawsuits from the Vioxx fall-out, the company is testing a new lung cancer treatment that stands to be a $1 billion per year power drug for the company.

The treatment, Keytruda, has been demonstrated to reduce the risk of death or the progression of the disease in cancer patients by 50%. These results have given Merck a 12-month head start ahead of Bristol-Myers, Roche Holding, and AstraZeneca, all of whom are racing to release the best new immune therapy treatment against lung cancer.

So finally the news for Merck is good and getting better 12 years after the Vioxx scandal that nearly destroyed the company.

Considering what Merck has become after the scandal, you’re probably wondering how you can spot a stock, or a sector, or the broader market, at a point of maximum pessimism.

Maximum pessimism isn’t a decline of a couple of percentage points. It’s when a stock has reached its lowest of lows. Headlines are terrible, and buyers have all but evacuated.

Investors won’t be able to buy at the exact bottom as no one can predict where that will be, but when fear rules, it’s time to buy. You may be a lonely buyer, which can be tough emotionally, and the price will almost certainly go down in the short-term.

But a good rule of thumb is to buy only those companies that are financially viable, so do your research. In Merck’s case, at its point of maximum pessimism it was still a drug producer that had several other blockbuster drugs on the market. The Vioxx scandal aside, the company was still profitable and still was able to invest in R&D, a drug maker’s lifeblood.

Investing at a point of maximum pessimism, when everyone else is fearful, isn’t easy and it requires patience and discipline. But if you can set your emotions aside and withstand some short-term pain, in the long run, you’ll have made a fortune.

Bottom line for Merck, while the point of maximum pessimism has passed for the stock, I think it’s still a decent buy. There’s a 12% upside in the short-term, and with its new cancer drug Keytruda, I think there’s great long-term potential.

And as for our two companies discussed at the beginning of this article, and discussed at length in prior Sunday Editions, Wells Fargo and Samsung, keep your eye on them.

Samsung isn’t traded on a major U.S. exchange, but is listed on the Korean exchange and is available as a GDR in London and Luxembourg. Wells Fargo on the other hand is traded on the NYSE.

The scandals these companies are going through today, and that Merck has been through in the last decade plus, are precisely the kind of unique troubles to look for from a contrarian standpoint as they send share prices lower temporarily, creating a great value.

Neither Wells Fargo nor Samsung are at the level yet where they’ve reached that point of maximum pessimism, but there will be a great buying opportunity for both soon, so keep a watchful eye on them.


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