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Summary

  • Big Pharma is in the midst of an impressive run. However, deep value stories can be found in any sector, even those that have outperformed.
  • After years of cost cutting and R&D rationalization, valuations for many in the pharmaceuticals group are still compelling.
  • We believe Merck is well-positioned for further upside.

By Kevin Holt

This is the third in a three-part series on sector opportunities as seen by a contrarian value investor - Senior Portfolio Manager Kevin Holt. The previous posts discussed financials and energy.

The pharmaceuticals industry is in the midst of a renaissance. Patent expiration concerns, pipeline disappointments and setbacks, and a highly uncertain regulatory backdrop have forced managements to rethink the way they have historically conducted business. In this environment, certain companies stand out to us as deep value opportunities - businesses whose stock prices don't reflect our view of their long-term potential.

Times have changed for Big Pharma

Pharmaceutical companies were once characterized by blockbuster drugs that were protected by patents for extended periods of time. In the early 2000s, investors began to fret about the future prospects of "Big Pharma" and its ability to weather an environment in which major patents were expiring, generic drugs were presenting more competition, and regulations were uncertain. These secular concerns pushed long-term valuations to historically low levels: Over the past 35-plus years, pharmaceutical companies in the S&P 500 Index have traded at a relative price-to-earnings (PE) ratio of 1.17x when measured against the broader index. At their trough in June 2009, valuations touched 0.69x - a 40% discount from their long-term average.

We too agreed that the pharmaceuticals business model had changed, but we did not agree that profitability would be impaired to the degree that was being discounted in the stocks. We became constructive on companies such as Merck (2.19% of Invesco Comstock Fund as of March 31, 2014), which is a great example of the type of multi-year value story that many other investors avoid at this stage, but that we seek out.

Today, Big Pharma, often associated with the more defensive areas of the market, is in the midst of an impressive run. From the market bottom of March 9, 2009, to mid-May 2014, pharmaceutical companies in the S&P 500 Index have outperformed the broader index by more than 700 basis points. By comparison, other defensive sectors such as consumer staples, utilities and telecommunications have broadly and meaningfully underperformed the index as a whole.

After a period of outperformance, one might expect the opportunity set to be less attractive for value investors - but that isn't the case with many pharmaceuticals. After years of cost cutting and rationalization of research and development capabilities, valuations for many in the group are still compelling. And we believe Merck (NYSE:MRK) is well-positioned for further upside.

Merck: Compelling valuation plus pipeline potential

Just as real estate professionals will tell you to focus on "location, location, location," my team focuses on "valuation, valuation, valuation." Merck is attractively valued, trading at 15x next year's earnings and has an attractive dividend yield. Currently, it's generating a 7% return on investment, whereas we believe that could grow to 10% in the next few years. (At the time we became constructive on Merck, its stock price was discounting a return on investment of only 2%.)

As is the case with most pharmaceutical companies, pipeline execution is central to Merck's outlook as an investment - the company is adding promising drugs such as immuno-cancer and hepatitis-C therapies to its pipeline. The hope is that the immunotherapy cancer drugs may be effective against multiple types of cancer. If approved, these therapies have the potential to revolutionize cancer treatments over the next several years, yet that potential is not reflected in the company's current stock price.

Beyond pipeline developments, management has been actively reorganizing the company by shopping sub-scale businesses such as Consumer Health.

The lesson here is that deep value stories can be found in any sector, even those that have outperformed, and we believe certain pharmaceutical companies, such as Merck, are well-positioned for further upside.

Important information

These materials may contain statements that are not purely historical in nature but are "forward-looking statements." These include, among other things, projections, forecasts, estimates of income, yield or return or future performance targets. These forward-looking statements are based upon certain assumptions, some of which are described herein. Actual events are difficult to predict and may substantially differ from those assumed. All forward-looking statements included herein are based on information available on the date hereof and Invesco assumes no duty to update any forward-looking statement. Accordingly, there can be no assurance that estimated returns or projections can be realized, that forward-looking statements will materialize or that actual returns or results will not be materially lower than those presented.

Valuation is the process of determining the current worth of an asset or company. There are many techniques that can be used to determine value, some are subjective and others are objective.

Price-to-earnings ratio is a valuation ratio of a company's current share price compared to its per-share earnings.

Dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its share price.

Return on investment (NYSE:ROI) is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.

Sub-scale refers to a business unit that is outside of a company's core activities.

The S&P 500 Index is an unmanaged index considered representative of the US stock market. An investment cannot be made directly in an index.

Invesco Comstock Fund's investment objective is total return through growth of capital and current income.

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Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

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The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. The opinions expressed are those of the author(s), are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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Source: A Contrarian's View Of Value: Pharmaceuticals