Two years ago, I outlined in this column why I was backing the pharmaceutical sector. Back then I saw the sector set to benefit from attractive demographics (an ageing population in the West, along with increasing wealth in emerging markets) and the technology changes arising from the mapping of the human genome in the late-1990s.
It had taken 10 to 15 years for the industry to generate a new wave of products based on biological rather than chemical research. Biological research, to my mind, was where the entire industry was moving. There was a significant amount of evidence “personalised” medicine could also become a major feature and that, I believed, would play into the hands of the drug companies in terms of success from pipelines.
At that time, investors’ focus was to a great extent on the challenges facing the industry as companies’ multi-billion-dollar revenue earning drugs were set to come off patent and their massive research and development budgets were showing few signs of delivering any replacements.
The success in 2013 of Bristol-Myers Squibb, among others, in novel oncology indications started to shift stockmarket perception of the sector and its growth potential with the new generation of more targeted drugs. Those companies – from mega-cap down to small biotech – perceived as having expertise in and exposure to this arena saw their shares regain premium ratings.
Roll forward two years and the sector has fallen somewhat out of favour again. As the chart shows, its price/earnings ratio is back down to its long-term average, with its traditional premium to the MSCI Europe p/e levels eroding (I have chosen to show the MSCI Europe index, as I currently hold both Roche in all and Novartis in some of the portfolios I manage).
A key issue now concerning investors is the stance on healthcare reform in general, and drug pricing in particular, taken by US presidential candidate Hillary Clinton. A typical elderly American, covered by Medicare, spends $500 a year out of their own pocket on prescription drugs and Clinton proposes capping this cost at $250.
She also hopes to increase competition by clearing the generic approval backlog, lowering the exclusivity period for biologics from 12 to seven years and allowing Americans to purchase pharmaceuticals abroad at lower prices. This, to my mind, represents relatively small scale tinkering (albeit with high profile coverage). Most importantly, even if enacted, I do not believe these measures would have a major impact on the profitability of the pharmaceutical companies I hold currently.
Further unsettling investors is the payers for healthcare in the US, the health insurance companies, are looking to lower costs and are taking on the drug companies by forcing competition between drugs with similar efficacy, irrespective of whether these are still on patent. Meanwhile, many of the breakthrough drugs have taken longer than hoped to get to market.
I view this setback in sentiment towards the pharmaceutical sector as likely to prove temporary. The sector’s demographics remain attractive and the biologically- based drugs are now a reality in terms of progression through the companies’ pipelines to gaining phase 3 FDA approval. These drugs, particularly in the fields of cardiology and oncology, offer a step change in the level of efficacy and, potentially, a very significant impact on quality and duration of life. As such, somewhere between governments and insurance companies, a way will be found to pay for them. And as the price comes down over time, so demand globally will rise.
My portfolios are exposed to a broad spread of pharmaceutical companies. In the High Income fund, the holdings at the mega cap end are AstraZeneca and Roche but it is also exposed to a wide range of much smaller cap companies.
Large companies no longer believe their scientific innovations need exclusively to be provided by their own research (access to novel science is now more democratised) and hence have adopted more flexible business models, which allow the drugs discovered and developed by smaller companies easier access to end markets. In a low-growth world where many industries have little pricing power, these pharmaceutical companies offer the scope for longer-term growth in earnings, cash flow and dividends.
Mark Barnett is head of UK equities at Invesco Perpetual