Eli Lilly’s Tremendous Year Leaves Investors with Big Decisions

Eli Lilly and Company (LLY) is one of the largest pharmaceutical companies in the world and is headquartered in Indianapolis. Many Hoosiers, especially those employed by the pharmaceutical giant, which often distributes stock grants as compensation, have been fortunate enough to accumulate sizeable stock positions.

Due to the phenomenal performance of LLY this year, investors holding the stock have likely seen their position size increase greatly as a percentage of their overall investment portfolio. So, what caused the run-up in Lilly's stock price, and what should investors holding these large positions do now?

Why Did Lilly's Stock Pop?

This year's increase in Lilly's stock price has garnered attention. In 2023, its share price has jumped over 60%, compared to just 17% for the broad S&P 500 Index. However, Lilly's relative strength is not a new phenomenon. In fact, over the last four years, LLY has outperformed the S&P 500 by over 7x (a gain of 433% for LLY compared to only 60% for the S&P 500)!

Lilly's stock price has benefited from its strong financial results. Earnings and sales have consistently been strong, often beating analysts' expectations. Revenue growth has benefited from increasing demand for many existing drugs, led by its breast cancer drug, Verzenio, and type 2 diabetes drug, Jardiance. Together, those drugs accounted for nearly an additional $550 million of year-over-year revenue growth and over $1.5 billion in total Q2 revenue.

Even more important, the company's growth has also come from its pipeline of new drug candidates for treating obesity and Alzheimer's. Mounjaro, a drug originally developed for diabetes, is expected to be approved as a promising weight loss medication and may even help curb addiction. However, the latter benefits have not been extensively studied. It has exploded in use this year, its revenues skyrocketing from $16 million to almost $1 billion. Additionally, the company's Alzheimer's drug, Donanemab, has shown positive results in its first Phase III clinical trial, further exciting the market.

Investors Face New Risks

While investors with Lilly stock have benefited greatly from this growth, many now face a new problem of dealing with a concentrated stock position, where this single stock has an outsized impact on performance. The risks associated with a concentrated position in a single company are magnified for those employed by the company or who depend on it for pension payments.

When a company's stock increases by such a large magnitude, its valuation can become quite rich, as measured by its Price-to-Earnings (PE) ratio. Since the beginning of 2020, LLY's PE ratio has increased from 15 to 84. By comparison, the S&P 500 Index's PE ratio was flat at 25 over that same period. This indicates that the stock may be "priced for perfection," and any less-than-stellar news could harm the stock's price.

What Can Investors Do?

Managing a concentrated stock position can be challenging, particularly when the shares have been accumulated in a brokerage account where capital gain taxes must be considered. Investors with concentrated positions should ideally strive to reduce the allocation to 15%-20% of their portfolio. This will help to protect them from a significant loss if the stock price declines. That said, the stock can continue to climb, even from these elevated levels. After all, the market size for drugs treating two of the world's biggest healthcare risks may be virtually unlimited.

So, what options do investors have?

Option 1: Do Nothing

Investors who continue to have conviction in the stock's future performance do not have to take any action. However, this should be an intentional decision acknowledging the potential risk of maintaining an unprotected concentrated position.

Option 2: Sell Shares to Reduce Position Size

If an investor chooses to sell the stock, the tax consequences of doing so must be taken into consideration. For those who have accumulated shares throughout their career, the cost basis is probably quite low, and any sale will likely incur a massive tax liability on the gains.

Option 3: Buy Put Options

For investors that do not want to sell shares, but still wish to reduce risk, buying put options is another strategy to consider. A put option is a derivative that protects the investor against a decline in the stock's share price. Essentially, it gives the investor the right to sell the stock at a specified strike price in the future, limiting the downside if the stock price falls below the strike price. The downside of this approach is that keeping the hedge in place can be quite expensive, and the puts may expire worthless if the price does not drop before the option expires. It is important to note that some employees of Lilly are ineligible to use options. If you are a Lilly employee, before implementing any strategy that includes options you should check with the company to ensure that you remain in compliance.

Option 4: Implementing a No-Cost Collar

Another strategy is to put in place a no-cost collar. This involves purchasing put options and simultaneously selling enough call options to cover the cost of the puts. The put option gives the investor the right to sell the stock at a specified price in the future while selling the call option limits performance above the specified strike price. If structured correctly, the premium on the put option is offset by the premium on the call option, so the investor pays no net premium for the strategy and still minimizes the degree of downside risk. This must be done carefully since many options contracts are thinly traded.

Option 5: Gift Shares to Charity

For those charitably inclined, appreciated shares of securities can be donated to charity. By donating appreciated securities, the individual can reduce their position in the stock while avoiding paying capital gains taxes. Since charities are exempt from taxes, they will not have to pay taxes on the gains when they sell the stock. Note that you must donate shares held for more than one year to realize the shares' market value for your charitable deduction. Shares held for less than one year only receive the cost basis as a deduction.

All of these choices can result in complex tax consequences. When holding a concentrated stock position, working with investment and tax professionals is important to ensure a particular strategy is done properly.

Summary

While the meteoric rise of Lilly stock has been a boon to many investors, managing the new risks associated with the stock is an important consideration to preserve gains and minimize risks for the total portfolio. To discuss what options are appropriate for you, contact your financial planner for specific advice.

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