biotech as buffett's wonderful business

Most people would say Warren Buffett, the famously tech-adverse investor who seeks "Wonderful Businesses", would never touch the biotechnology sector. However I believe this is simply a function of his  circle of competence principal.  Simply, if he doesn't fully understand a business, he won't allocate it his capital.

Do some  investor's circle of competence include biotech? Of course, but does the biotech sector contain "Wonderful Businesses"? Let's find out.

Time is the friend of the wonderful business, the enemy of the mediocre.
-Warren Buffett, 1989 Chairman's Letter

So what is a Wonderful Business? Investopedia has a nicesummary of Buffett's wonderful business criteria:

Buffett's criteria for "wonderful businesses" include, among others, the following:

1. They have a good return on capital without a lot of debt.
   
2. They are understandable.
   
3. They see their profits in cash flow.
   
4. They have strong franchises and, therefore, freedom to price.
   
5. They don't take a genius to run.
   
6. Their earnings are predictable.
   
7. The management is owner-oriented.

For the purposes of this post, I am going to focus on the factors we can easily quantify, specifically items one and three. Return On Invested Capital, item one, is certainly the most important. It's also worth noting that this criteria works. 

"Leaving the question of price aside, the best business to own is one that over an 
extended period can employ large amounts of incremental capital at very high rates 
of return.  The worst business to own is one that must, or will, do the opposite - that
is, consistently employ ever-greater amounts of capital at very low rates of return."     
-Warren Buffett, 1992 Chairman's Letter

There are many "cheap" companies, but not many that earn high returns on capital. Let's look at Berkshire Hathaway's publicly traded holdings to see what Buffett considers an acceptable ROIC.

For those who completely dismiss The Oracle's interest in biotech, I will point to Berkshire Hathaway's quarterly 13F filing. As of December 31, 2013 Bershire owned shares in Sanofi Aventis and Johnson & Johnson.  Although these are "pharma" and not "biotech", the truth is that the distinction between the two sectors has been getting blurrier every year.  Biotech is simply next-generation pharma. Case in point, J&J is the world's fifth largest biologics company, and Sanofi's Tuberculin for diagnosis of  tuberculosis is a Purified Protein Derivative. 

Let's check out the ROIC's  of Berkshire Hathaway's healthcare companies. (Yes, I know DaVita is not Buffett's position, but rather Ted Weschler's)  Also, they recently sold out of GSK, but it's worth noting for our purposes.

So we've established that Berkshire Hathaway, and by extension Buffett, has invested (to a limited extent) in companies that sell biotechnology products.  But what about the criteria outlined above? What about a pure play biotech company?

Gilead Sciences is the second largest component of the NASDAQ Biotechnology Index at 8.4%. This maker of Hepatitis and HIV antiviral drugs was founded in 1987 and then went public in January 1992. 

Gilead has followed the path of many growing companies, operating at a loss for the first several years before finding success. It wasn't until the second quarter of 2002 that Gilead earned a profit, and since then it has earned an excellent average ROIC of 26.9% over the past five years, nearly as much as Buffett's fourth largest holding IBM.

Below I've shown regular ROIC, and Cash Return on Capital Invested, to smooth out some accounting charges that do not impact cash.

What about criteria number three, profits as cash flow? Turns out Gilead is pretty good there too, with the same exceptions of some accounting write downs, Earnings and Cash Flow from Operations have tracked each other very closely.

So we've established that biotechnology can, quantitatively, meet the definition of a "Wonderful Business". 

Interesting side notes: 

• Michael L Riordan, Gilead Founder  attempted to recruit Warren Buffett as a board member in 1988. Buffett quipped "Sorry, but I would bring nothing to this enterprise except my name".
  

• To further illustrate the blurring lines between pharma and biotech, Gilead's antivirals are small molecule drugs, which are typically associated with pharmaceutical companies.
  

• Since Gilead started earning a profit in 2002, the stock has gone up.  See below. Like I said earlier, this stuff works.

It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
-Warren Buffett, 1989 Chairman's Letter

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.