Where to find value in pharmaceuticals

The glory days of the pharmaceutical giants may be over, says Charlie Gibson but that doesn't mean there isn't value to be found.

One of the hardest aspects of investing is that markets price shares based on what investors believe is going to happen in the future not on what is happening right now. This is known as discounting' the shares of a firm are said to discount' a certain performance before it actually happens. Why is this a problem? Let me explain.

If a firm expects to achieve a certain amount of growth in 24 months, and the market believes it, then assuming the shares are sufficiently below this level, investors will pile in. Inevitably, the share price gets ahead of itself, so that within, say, 15 months, it is actually higher than the firm's future growth prospects justify. Smart investors start to realise this, followed by less observant ones, and everyone gets back out of the shares, driving them back below their fair value. So while the fundamental value of a company is important, you also need to have an idea of when to buy and when to sell and it is precisely this problem that I have developed my own investing model to answer. There isn't space to describe how it works here, suffice to say that it has given me some good trading signals in the past. And one that has come up recently concerns pharmaceuticals giant GlaxoSmithKline (GSK, £14.02).

The story of Glaxo has been nothing if not dramatic. A series of breathtaking deals in the mid-1990s catapulted it onto a global stage hitherto dominated by the Americans. At the time, the chemicals industry was fragmenting into distinct chemical and pharmaceuticals entities and Glaxo was able to gather around itself a formidable array of patents and products. Patents protected older products, which generated high enough returns to develop new products, which could then be rolled out down the same sales pipeline as their predecessors. Earnings growth was regularly in the mid- to upper-teens and the shares rose from £5 to a high above £23 in early 1999.

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But it wasn't to last. Whereas previously the pharmaceuticals industry had exercised a tight hold over new products via its funding of the research and development (R&D) pipeline, increasingly investors were prepared to fund independent biotech operations to develop alternative drugs instead. Unwilling or unable to pay the premiums needed to buy out these new entrants, big pharmaceuticals lost control of the R&D pipeline. Costs went up, returns went down and the entire industry's new drugs pipeline key to future growth began to dry up. As growth faltered, so the old pharmaceutical giants began to be seen as ex-growth stocks, trying to eke out the last few pounds of profit from their legacy product portfolios. Worse still, there then came a deluge of challenges to the patent protection on their historic products. As their image waned, so did their premium valuations. From an historic p/e of 36 at the end of 2000, Glaxo's rating fell to under 14 in 2004.

But has this re-rating now gone too far? Big pharmaceuticals' glory days may be over, but they still have plenty to recommend them. The flood of money into biotechnology has dropped off to the extent that the sector is increasingly seen as a way for big drug groups to replenish their depleted product pipelines, and regain some control over R&D. As the world's second-largest pharmaceutical group, Glaxo should be well positioned to take advantage of its size and status to make judicious acquisitions in this area. It has defended its patents well and still retains the trust of governments to manage major public health threats, such as bird flu.

From the mid- to high-teens in 2000 and 2001, earnings growth fell to below 10% in 2002 and 2003 before turning negative in 2004. But since then, it has begun to recover; growth was 9% in 2005 and should be around 16.5% in 2006, though full-year results are not yet available as we go to press. Assuming no major changes, growth in 2007 and 2008 should be around 4% and 5% respectively. For the four years to 2010, it is expected to be 6% (compound). Not very exciting but slow, steady growth should not be sniffed at. Many other FTSE 100 stocks have comparable earnings-growth expectations. The difference is that the market never expected any better from them, so they have not been punished for disappointing, whereas the pharmaceutical giants have. As a result, Glaxo now trades on a multiple of only 14 times 2007 earnings well below the market average.

Certainly, things have been tough in the pharmaceuticals industry in the past few years and look set to remain so. Yet Glaxo has traded on a multiple of almost 18 times historic earnings in each of the past two years. As a result, my model tells me that Glaxo's shares are already discounting all of the foreseeable bad news and that, as long as nothing new comes along to buffet the industry or Glaxo itself, the scope for the share price to fall from current levels is limited. I have Glaxo as a buy up to £14.09 and a sell above £18.79.