- The pharmaceutical industry is facing regulatory headwinds amidst positive global trends.
- Fundamentals show that all the positives are already priced in leaving more downside room than upside potential.
The pharmaceutical sector has been one of the worst performers in 2016. It’s down 11.22% year-to-date while the S&P 500 is up 13.37%.
From a longer-term perspective, the pharma sector has largely outperformed the S&P 500. From the low point in the 2009 financial crisis, the iShares U.S. Pharmaceuticals ETF (IHE) has gained 291% while the S&P 500 has gained 233%.
Today, we’ll analyze sector trends, risks, and the fundamentals of potential pharmaceutical investments to see if the recent pullback is an investment opportunity.
As I’ve already mentioned, the pharma sector has outperformed in the last 10 years but has underperformed in the last year and a half.
Figure 1: U.S. pharmaceutical ETF and the S&P 500 in the last 10 years. Source: Nasdaq.
One of the main reasons behind the pharmaceutical underperformance in the last two years comes from the negativity surrounding the sector over the constant rise in drug prices. Fear of higher regulatory scrutiny and involvement broke the wonderful growth story and pushed pharmaceutical stocks 25% below their 2015 peak.
The increased scrutiny has severely affected companies whose strategy was to buy old drugs rights and significantly increase prices. A good example is Valeant Pharmaceuticals International (NYSE: VRX) which has seen its stock price decline 95% since 2015.
Figure 2: Valeant’s stock price. Source: Nasdaq.
Increased scrutiny and more regulation is something that the industry won’t be able to avoid. But leaving ethical and political issues aside, the trends in the industry are still very positive. In the developed world, the population is aging, while in the developing world, the population is, well, developing. Both cases will increase demand for pharmaceuticals. Chronic/lifestyle diseases are also growing while spending on drugs is consistently increasing and the growth isn’t really even affected by recessions.
Figure 3: U.S. GDP and pharmaceutical expenditures per capita. Source: FRED.
Increased spending in the U.S. and in the developing world is expected to bring the pharmaceutical market to $1.4 trillion in 2019 which translates into a yearly growth rate of around 7%.
Figure 4: Expected pharmaceutical industry growth by 2019. Source: Deloitte.
The expected growth may be a little lower if more price regulation hits the market, or higher if corporations manage to lobby their way into higher profits.
Nevertheless, it’s of extreme importance for investors to look at fundamentals as from a business perspective we know that people are using drugs and will continue to use them. What’s also very important is that sales won’t be severely affected if a recession comes along, making the sector a great defensive play.
A look at fundamentals will tell us if it’s a good time to contemplate investing in pharmaceuticals or if we should wait for better opportunities and invest elsewhere in the meantime.
I always prefer to look at the fundamentals of the 10 corporations with the largest weight in the sector. This gives me a pretty good picture of the whole sector and isn’t biased by the usually faulty ETF aggregate fundamental metrics.
Unfortunately, the fundamentals aren’t great. Cyclically adjusted price earnings ratios are higher than current PE ratios indicating that companies are squeezing the current boom cycle, dividends are relatively low and close to 100% of earnings, while debt to asset ratios and price to book values don’t indicate a healthy margin of safety.
We can conclude that the positive demographic and global development trends affecting the industry are already priced in while the risk of higher regulatory pressures is minimal according to the market. The general pharmaceutical sector is therefore to be avoided as increased regulatory scrutiny will possibly put pressure on earnings. Even if this doesn’t happen, PE ratios around 30 don’t make the 7% yearly expected growth rate a great deal.