Snap up drug stocks while they're still cheap
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Associate Editor
David Stevenson Oct 12, 2009
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Snap up pharmaceuticals while they're cheap
Investors used to love drug stocks. But not any more.
At the start of the 'noughties', leading pharmaceutical firms were much higher rated than your average share. Yet now, what a contrast we're seeing – as the decade draws to a close, big pharma is trading on big discounts to the market.
That's one good reason why we think now is a great time to buy into the sector. But it's far from the only reason to buy big pharma today...
The Amex pharmaceutical index of major US drug companies was once very well-regarded by investors. As the new millennium dawned, according to Bloomberg data, it was trading on a price/earnings multiple 40% higher than the S&P 500 index. In other words, drug stocks were all the rage and people were willing to pay a lot to have them.
Yet nearly ten years later, the Amex index valuation has dropped to below 40% of the Wall Street benchmark.
Sure, during the worst ravages of the bear market in 2008 and early 2009, global drug stocks did manage some relative catching up. Not because they were rising, but because everything else was crumbling around them. But sadly for US pharma investors, much of that comparative pick up has since evaporated. And it's the same story in Europe – drug companies have been savagely devalued here, too.
How has pharma fallen out of favour?
It's partly down to profits growth – or more precisely, the lack of it. Drug companies aren't able to make the sort of margins that they used to. Last November in MoneyWeek magazine, my colleague Eoin Gleeson spotlighted the impact of cheaper generic drugs as patents expire (The 'new age of thrift' will benefit copycat drugs). Further, it has proved harder, and more costly, to find new blockbuster compounds – the so-called 'product pipeline'. And while healthcare spending has climbed, there's a limit to how much hospitals, and patients, can afford to pay.
Then "there's a consensus that big pharma is undervalued today due to worries about health reform", says the Motley Fool. But that, it believes, is "unnecessary".
On top of this, big pharma's recent underperformance has been largely due to the sector being seen as 'defensive', i.e. it doesn't need economic growth to make its money. At a time when stock markets have focused on shares that might do well out of a recovery, defensive shares have been largely left on the shelf. And drug stocks have been among those shunned.
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Why now is the time to buy
But this could all be about to change. That's partly because many other shares, mostly cyclicals which depend heavily on a buoyant economy for their profits, have now become extremely expensive.
Take the US, for example. As David Rosenberg of Glusken Sheff has consistently said, the market rally of the last six months has been all about valuation – what he calls "an unprecedented expansion in p/e ratios". Indeed, he further points out that when all the write-downs being made by US companies are removed from their profit figures, the "trailing" p/e on reported earnings just widened to its "highest in recorded history of nearly" – wait for it – "140 times, which is three times the levels prevailing during the height of the tech bubble".
Meanwhile the current S&P 500 market dividend yield has fallen to a mere 2.3%. In other words, there are now lots of very expensive stocks around, pricing in loads of good news that may well not happen.
Compare this with the valuations of US big pharma. Here, it's a classic case of negative news being factored into the price of stocks that then fall right out of fashion. This creates a great value opportunity for savvy contrarian investors to buy in amid all the negative vibes.
The pharma bargains
A glance down the list of valuation ratios in the sector throws up some very appealing cheap stocks. Here are some of the best: Bristol-Myers Squibb (NYSE: BMY) is on a 2010 consensus forecast p/e of just 10.2x, and a prospective yield of 5.6%. Merck (NYSE: MRK) is cheaper on a forward multiple for next year of 9.4x, although the forecast yield is 4.7%. Pfizer (NYSE: PFE) is even more lowly rated on an expected 2010 p/e of 7.4x and a 4.5% yield, while Eli Lilly (NYSE: LLY) has a forward p/e of just 7.3x, with a forecast yield of 6.2%.
Europe's major drug stocks are in the bargain basement too. Novartis (VX: NOVN) in Switzerland trades on a 2010 forecast multiple of 11.4x, with a forward yield of 4.5%. Meanwhile next year's expected p/e for the French company Sanofi (FP: SAN) is just 8x, with a prospective yield of 5%.
You get the picture. At worst, global pharma now looks great value. At best, buying at this level could make you some decent money.
What about in Britain?
GlaxoSmithKline (LSE: GSK) and AstraZeneca (LSE: AZN) are in the same cheap boat. Both have suffered similar de-ratings to their American cousins – down to forecast 2010 p/es of 10.3x and 7.8x respectively, and prospective yields of 5.2% and 5.4%.
Yet both remain out of favour. As Invesco Perpetual's Neil Woodford points out, 28 brokers see AstraZeneca as a 'hold' or less, with only seven rating it as a 'buy'. But despite risks like those patent expiries, which he reckons are 'priced in', he's snapping up the shares.
They're "the cheapest assets in the stock market today", he tells Citywire, "rated in a way that ascribes no growth going forward. But they're extremely cash generative. I see them as financial assets, not just drug companies, and as such they're incredibly cheap".
What's more, "there's a huge burgeoning market in China, India and Latin America, as well as Eastern and Northern Europe - a new growth dynamic nobody seems to want to talk about", he says. "I think it's very significant. The market seems not to see the opportunity here".
We'd suggest snapping them up now before everyone else notices.
Before we go, we wanted to let you know about the World MoneyShow, coming to London at the end of this month. It's your chance to hear the latest views and investment strategies from a wide range of experts including Marc Faber of the Gloom, Boom and Doom report, and Seven Investment Management's Justin Urquhart Stewart. Several members of the MoneyWeek team are speaking too, including our resident share tipper Paul Hill, gold and commodities expert Dominic Frisby, and MoneyWeek editor John Stepek. The show takes place at the Queen Elizabeth II conference centre on Friday 30 and Saturday 31 October. Find out more here.
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