Buy Big Pharma – the deal spree could be just beginning

With pharmaceutical stocks still looking cheap and some very smart deals being done, it’s a good time to buy in to the sector. John Stepek explains how.

140424-glaxo

At the nadir of the financial crisis in March 2009, I decided it was time to buy some shares.

I wasn't at all convinced that the market had bottomed out. In fact, I expected it to fall further.

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But I also thought that there were at least a few blue-chip companies who were probably as cheap as they were ever going to get, bar the entire world collapsing into a black hole.

And as we were saying it was time to buy blue chips in MoneyWeek magazine, I also thought it was only right I should have some skin in the game' in case we were wrong, and the world did collapse into a black hole.

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Looking back, of course, I wish I'd bought some gloriously spivvy little Aim stock, or a credit-starved car dealership, or a manufacturer at death's door. I'd have made multiples of my original money.

But no. I bought perhaps the most boring blue chip in the entire FTSE 100. The good news is, it looks like it might now be paying off

Smart deals in the drugs sector

GlaxoSmithKline (LSE: GSK)

But I have to say, I really like this company. It's the least-stressful stock I've ever owned. It pays a nice steady dividend. It never falls enough to make you panic, and it never rises enough to make you think "is it time to sell?"

However, it looks like life in the Big Pharma sector might be about to get more exciting. This week the industry caught merger-mania.

One of our tips in the New Year edition of MoneyWeek was AstraZeneca, on the basis it was bound to get taken over this year. It seems that's what's happening now, with a rumoured approach by US giant Pfizer.

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Meanwhile, Glaxo and Swiss peer Novartis did a very sensible-looking asset swap. Glaxo swapped its cancer research units for Novartis' vaccine business. As John Gapper notes in the FT, this is a clever deal.

Both companies get to specialise and focus resources on areas they are good at. To paraphrase Novartis' chief executive, Novartis can get more value out of Glaxo's cancer labs than Glaxo can, while Glaxo can make Novartis' vaccines business work harder.

If it works, everyone's a winner. Consumers get more new drugs, more quickly. Shareholders and managements avoid the indigestion problems that always come with any big merger. And nobody has to shell out ridiculous fees to investment banks to broker the whole thing.

Healthcare stocks still look cheap

As Leonid Bershidsky notes on Bloomberg View, McKinsey found that while mergers in most industries deliver no added value (or subtract value, in the case of the tech sector), that's not the case for pharma. "Median excess returns for megamergers in our sample were positive." In other words, the deals actually made sense at least for shareholders.

John Authers also notes something interesting in this morning's FT. He takes a look at Deutsche Bank's Croci' method of value investing.

The methodology is rather finicky investment analyst departments need to justify their existence somehow and coming up with time-consuming valuation methods with rubbishy acronyms is a good way to do it.

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But at its core, it's quite sensible. The whole point of value investing is to find out what a company is really' worth. If the company's true' value is sufficiently higher than the market's valuation of it, you buy. (That's your margin of safety').

The Croci approach tries to get a better idea of this true' value than you'd get from traditional ratios, by throwing more details into the mix.

So the analysts look at enterprise valuerather than market capitalisation (so you look at debt as well as equity), for example. They also try to account more accurately for the value of both tangible assets (factories and the like) and intangibles (brands and patents).

A lot of this stuff is subjective of course but probably not as biased as the spin the company puts on its own accounts.

In any case, the system has worked reasonably well. An index based on the strategy has beaten the wider markets in both the US and Europe since it launched a decade ago.

And why is it relevant to this topic? Because it suggests healthcare has been one of the three cheapest sectors in the world every year since 2009. And that in turn suggests that there's plenty of reason to expect investor interest and merger activity to continue.

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If you want exposure to the big pharma story, you could buy (or stick with) GlaxoSmithKline (LSE: GSK) or AstraZeneca (LSE: AZN) in the UK. Alternatively, you could consider a healthcare-focused investment trust such as the WorldWide Healthcare Trust (LSE: WWH) although bear in mind that this trust has a lot of exposure to biotech stocks, which are a lot more expensive than their less sexy Big Pharma counterparts.

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