The fact that people will always get sick and need drugs, and prioritise healthcare over other spending, creates a sustainable demand for pharma products that is independent of the economic cycle. Demographic trends also support the defensive case as the global population continues to grow and age. However, undesirable side-effects to the sector have also emerged, making it a little less effective than other defensive sectors.
In recent years traditional pharma companies have been battling the cancer of the generic drug manufacturers (which make exact copies of drugs that have lost patent protection). A patent cliff is fast approaching, with around $54bn (€42bn) of drug revenue set to be eroded over the next few years.
Collision course with austerity
In addition to the patent cliff, the global recession has highlighted just how expensive it is for the state to support growing and ageing populations. Most governments looking to reduce public expenditure have historically chosen to make cuts in non- health areas.
But with government-funded healthcare programmes such as the NHS and Medicare/Medicaid reaching unsustainable levels of cost, the hitherto sacred cow of healthcare funding is coming under the knife – and that affects drug pricing. The traditional pharma sector mantra that people get sick and need drugs has moved on: now, people get sick and need drugs at lower cost.
Taken together, these undesirable side-effects have introduced earnings volatility as key patents expire and pricing uncertainty emerges. As a result, the sector has not performed as well as might have been expected during the downturn. While the core defensive argument remains intact, there are other factors that need to be considered when investing in a sector undergoing significant change:
- Be wary of the value traps. The de-rating of the sector makes valuations seem attractive, especially for dividend yields, but such carrots often distract from lame donkeys. High exposure to patent expirations, coupled with poor pipeline opportunities, justify the low multiples of some companies, such as AstraZeneca, and make any near-term re-rating look unlikely.
- Buy the pioneers. The more successful companies such as Roche have been innovators, not enhancers, employing cutting-edge science to develop new drugs. Although it can be risky, this approach has been rewarded with a number of approvals and better pricing as organisations that pay for drugs are prepared to accept higher prices for truly innovative medicines.
- Be fashionable. Interest in therapeutic areas comes in waves. Recently breast cancer, prostate cancer, hepatitis C and multiple sclerosis have seen significant advances in treatment options, and Alzheimer’s and diabetes have high profiles at the moment. Rare diseases are also a growth area with Shire and Genzyme (now part of Sanofi-Aventis) in Europe, and Biogen Idec in the US all providing good exposure.
Sector in transition
While the sector will remain defensive, tectonic shifts are occurring. The defensive stalwarts that dominated recessionary portfolios in the ’90s and early ’00s will continue to pay high dividends given the cash flow from mature products and infrequent new mini-blockbusters.
High exposure to patent expirations coupled with poor pipeline opportunities justify the low multiples of some companies
In the longer term, the generic drug companies could be an attractive substitute. Although the generic pharma sector is still growing, the high-volume products and commoditised but non-cyclical market will eventually stabilise. In addition, the dividend yields on the larger companies such as Teva are growing.
The more conservative way to play these trends in the near term may be by means of diversified exposure to generic and biotechnology through funds. For the defensive element, investing in high-quality, well-run companies with limited exposure to the patent cliff and a rich, diversified pipeline is likely to remain in favour. Here we like Roche, Novartis and GlaxoSmithKline.