Now's the time to buy into big pharma stocks
Big pharmaceutical stocks have had a bad time over the last decade. But they're due a turn around, says David Stevenson. Here, he explains why the future for drugs companies is brightening, and tips two of the best stocks in the sector.
As we've been saying for a while, between Europe's ongoing crisis, and the threat of a slowdown in both the US and China, the global economic outlook isn't too promising right now.
That means you should stick to investing in sectors that don't need rampant growth to make their profits.
For a start, these defensive sectors generally represent the best value around in the stock market right now. What's more, you can find a range of stocks that yield more than even Britain's - inflation rate.
One such sector is 'big pharma'. Many of the world's major drug companies haven't had a great time over the last decade. Yet they're now due a big change of fortune.
No two ways about it big pharma is cheap
Near the top of the 'defensive' stocks list is the global big pharma sector. After all, the world's consumers will always need to spend money on healthcare. So you might expect to have seen people piling into it.
Yet over much of the last decade, this once-popular part of the market has fallen right out of favour. Investors have preferred to buy into a mix of cyclical and growth stocks. As a result, the S&P pharmaceutical index, for example, has lost almost a quarter of its value since 2001.
This underperformance has come about despite steady profits growth. The weakness in the sector is due to many major pharma stocks being savagely de-rated. In other words, their p/e (price to earnings) ratios have been slashed, as investors place less and less value on these companies' future earnings.
Why? Because many former blockbuster drugs either have lost, or soon will soon lose, their patent protection. That means these medicines can then be copied by 'generic' rivals and sold on the cheap. In turn, there'll be less profit to be made from these products.
Up to $100bn in sales could be lost by global drug firms over the next three years. Meanwhile, in its search for replacement products, the industry has so far been firing plenty of blanks.
At first glance, that doesn't sound too promising. So why would the big pharma sector appeal to investors now?
The fact is, market chatter about the so-called 'patent cliff' has been knocking around for ages. So by now it's been firmly baked into the share prices of major drug makers. And as a result of those de-ratings, several of these companies now look downright cheap.
Better yet, the sector's dividend payouts have been steadily rising for years. Compared with those lower share prices, this means that the yields on many big drug stocks are now well above average.
In short, big pharma has become great value. And for investors, that's a great starting point. Indeed, over the last three months, the healthcare sector has proved to be just about the best performer around as the market sussed out the value on offer.
The outlook for drug discoveries is brightening
But the investment case for big pharma is based on more than just low valuation and decent yields. What markets like to call 'sentiment' is now on the upturn as drug companies finally get their act together.
That's because "after years of research flops that led some to write its obituary, the pharmaceutical industry shows signs it's coming back to life", say Jonathan Rockoff and Ron Winslow in the Wall Street Journal. "Credit a revamped research approach, which after focusing on me-too drugs for ills that were already well treated, is pouring firepower into diseases that aren't".
This new way of unearthing the next set of blockbuster drugs is already paying off. Getting marketing approval from the US Food and Drug Administration (FDA) is seen by the industry as the swing factor in launching a fresh product. So far this year, pharma firms have won the FDA's say-so on 20 new medicines that work better than existing drugs or tackle conditions that lack decent treatments.
If this pace of innovation keeps going, it will be the best year for new drug approvals for 10 years. OK, this wouldn't by itself make up for that $100bn in lost revenues. But with global medicine sales set to top $1.1 trillion, it could be the catalyst for investors to hastily rethink their gloomy view on big pharma stocks.
So what to buy? This is a sector we've been keen on for some time. For example Pfizer (US: PFE), which we recommended a year ago, has since risen by some 30%. But on a current year p/e of below nine, and 4% prospective yield, it still looks a good bet.
We'll be writing more on specific stock tips soon in a future issue of MoneyWeek magazine [If you're not already a subscriber, subscribe to MoneyWeek magazine. But in the meantime, you could take a look at the London-listed Worldwide Healthcare Trust (LSE: WWH). It's an investment trust that holds a basket of global pharma stocks.
WWH trades at a discount of 7% to the assets it holds, so you're already a bit ahead of the game. The biggest holdings in the trust include drug majors Novartis (6.5%), Roche (6.1%) and Pfizer (5.4%). It also invests in biotech firms.
The trust has a good longer-term track record. As stock markets re-discover the benefits of re-investing in big pharma, this is only likely to improve further.
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