Does Novartis AG (ADR) (NVS) Pass Buffett’s Test?

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We’d all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital, or ROIC, to help determine whether a company has an economic moat — the ability to earn returns on its money above that money’s cost.

Warren Buffett

In this series, we examine several companies in a single industry to determine their ROIC. Let’s take a look at Novartis AG (ADR) (NYSE:NVS) and three of its industry peers, to see how efficiently they use cash.

Of course, it’s not the only metric in value investing, but ROIC may be the most important one. By determining a company’s ROIC, you can see how well it’s using the cash you entrust to it and whether it’s actually creating value for you. Simply put, it divides a company’s operating profit by how much investment it took to get that profit. The formula is:

ROIC = net operating profit after taxes / Invested capital

(Get further detail on the nuances of the formula.)

This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers, and it provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficiently the company uses capital.

Ultimately, we’re looking for companies that can invest their money at rates that are higher than the cost of capital, which for most businesses is between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company’s economic moat.

Here are the ROIC figures for Novartis AG (ADR) (NYSE:NVS) and three industry peers over a few periods.

Company TTM 1 Year Ago 3 Years Ago 5 Years Ago
Novartis 11% 10.7% 15.5% 13%
Merck & Co., Inc. (NYSE:MRK) 10.1% 12.8% 6.9% 19.9%
GlaxoSmithKline plc (ADR) (NYSE:GSK) 17.6% 26.6% 26.4% 28.7%
Pfizer Inc. (NYSE:PFE) 10.8% 9.4% 8.4% 15.7%

Source: S&P Capital IQ. TTM = trailing 12 months.

Of the listed companies, only GlaxoSmithKline plc (ADR) (NYSE:GSK) meets our 12% threshold for attractiveness. However, its returns have declined by more than 11 percentage points from five years ago. Novartis AG (ADR) (NYSE:NVS) and Pfizer Inc. (NYSE:PFE) both come close to meeting our 12% threshold, but they’ve also seen some declines in their returns from five years ago. However, all of these companies offer healthy dividends: Novartis AG (ADR) (NYSE:NVS) at 3.4%, Merck & Co., Inc. (NYSE:MRK) at 3.6%, GlaxoSmithKline at 4.2%, and Pfizer Inc. (NYSE:PFE) at 3.3%.

Novartis AG (ADR) (NYSE:NVS) is active in both the proprietary and the generic drug markets. This diversity offers key benefits. While proprietary drugs can help a company’s profits skyrocket, they also expose businesses to rapid drops in revenue as patents expire and regulatory changes cause consumers to pursue lower-cost options. While Novartis AG (ADR) (NYSE:NVS)’ involvement in the generic drug market may not offer the same growth potential, it can help the company maintain more steady revenues.

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