Time to Invest in Pharmaceuticals?

by: Howard Sun

The prices of many pharmaceutical companies have been beaten down by Wall Street in recent months. With companies like Pfizer (NYSE:PFE), Schering-Plough (SGP) and Bristol-Myers Squibb (NYSE:BMY) reaching lower lows, one has to wonder when the pain will end as these companies are now significantly undervalued.

The game of Wall Street is far from what many believe is true of the strong-form efficient market hypothesis – that the stock market efficiency causes share pries to always incorporate and reflect all relevant information. Since a majority of the market is comprised of traders’ expectations of future prices based on past information, the underlying human element disputes this theory. What typically happens in an economic cycle is that the stock of a company or even the value of an entire industry grows oscillates beyond fair value.

For example, if company A trading at $10 is in an up cycle with valuation of $20; the stock usually rises way above that valuation, perhaps $30. When the same stock hits a down cycle and is still valued at $20, the price is often battered to $10. In the long-term, the stock price may stabilize near the consensus value, but in the short term you are more likely to see fluctuations.

Many investors have abandoned the pharmaceutical industry lately due to the lack of drug pipelines, blockbuster patent expirations, a more stringent FDA, generic competition, research failures, scandals and drug safety concerns. Because of this, many companies have been battered to the ground.

Big Pharma have realized this evolving market place and many are undergoing multi-year transformations to change the way they do business.

For example, many of them are now focused on cutting out the “fat” that they’ve accumulated over the years. Companies are also developing new systems, technologies and sales tools to combat the increasingly hostile environment. Instead of focusing on developing blockbuster drugs, companies are spreading their resources into more focused indications on smaller patient populations. They’re entering newer markets, particularly in Asia where significant growth opportunities exist. They’re also participating in more JVs, co-promotes, and acquisitions to prop up their pipelines. Finally, companies are outsourcing many activities like R&D, clinical research and sales to third-parties.

It’s not uncommon to see industries undergo drastic transformations like the one taking place for pharmaceuticals; we’ve seen it happen previously be it in Consumer Goods, Automotive, or Telecom just to name a few. Certainly this is just part of the cycle that every industry needs to go through.

The pharmaceutical industry is not only attractive for its high-paying dividend yields; a weaker US Dollar has helped overall earnings due to strong sales in international markets. In addition, many companies are currently trading at low multiples (to earnings and to sales). Valuation analyses suggest that many companies are now cheaper than the sum of their parts.

Instead of looking for the next blockbuster, the prudent investor will look for where true value exists. You’ll probably not witness huge returns like those after Hillary’s universal healthcare collapse during Clinton’s presidency; there are still great benefits to be reaped however. In the end, how can you beat a business that makes a pill for a few pennies and sells for a few dollars? The economics are just too good to avoid!

Disclosure: none