Mundy: Why pharmaceuticals won’t hit tobacco’s heights
The Investec manager says the people drawing parallels between the sectors are simply being naïve and are trying to convince themselves they won’t miss out on the next big thing.
One of the interesting benefits of meeting clients is that they often provide insights into how our competitors view the world. It’s a particularly revealing exercise when we hear the same message repeatedly as it suggests a consensus view has formed; an event that naturally raises our contrarian antennae.
A common view we have heard recently is that despite concerns over patents, pricing, pipeline and regulation, the much-maligned pharmaceutical sector is attractive.
This argument is supported by drawing parallels with the tobacco sector of a decade or so ago: despite its pariah status at the time as a sector in structural decline and with ongoing legal expenses, tobacco stocks have performed phenomenally – up by more than 650 per cent in total return terms since the end of 1999. So why, say these bulls, shouldn’t pharmaceutical stocks pull off the same trick?
While considering this point I have been skipping through Thinking Fast and Slow by Daniel Kahneman, a psychologist who won the Nobel Prize for Economics in 2002 for the work he conducted on uncertainty and decision making, with his academic partner Amos Tversky. The book is semi-autobiographical and a great read.
Two biases that Kahneman revisits from his work with Tversky, and which seem highly relevant to the tobacco versus pharmaceuticals discussion, are those of availability and representativeness.
A pinch of regret should also be added to this emotional cocktail. The representativeness heuristic (short-cut) encourages the brain to search for historic events that are similar to the current experience.
As a large defensive stockmarket sector with earnings under pressure and a number of factors threatening its longer-term success, some investors find it tempting to pair up the pharmaceutical sector with the tobacco sector of a decade ago.
The availability heuristic is a mental shortcut that uses the ease with which examples come to mind to make judgements about the probability of events. The regularity with which BAT reaches all-time share price highs certainly makes it a very available example of how large blue chips can regain their mojo.
Regret is a tough emotion for us all to deal with: "Why didn’t I buy that stock/bet on that horse/use that great line?"-type questions remind us that the future may have been significantly better if only we had taken a slightly different course.
It must be galling for those technology investors busy using their price/eyeball ratios in the late 90s to assess the cheapness of stocks, when a simple old-fashioned low price/earnings ratio would have pointed them towards far superior investments.
It is too late to correct that oversight, but not too late to try and learn from it. And with tobacco stocks some of the biggest constituents of the FTSE 100 – BAT and Imperial Tobacco have a combined weighting of more than 6 per cent – regret just keeps prodding away.
Of course, over the years there have also been a number of stocks that exhibited elements of structural decline and then proceeded to generate extraordinary underperformance.
However, these stocks, as a result of their appalling performance, are not high profile and therefore are more easily forgotten. Availability bias focuses investors’ minds on the easy-to-remember winners while representativeness bias is dangerous as it encourages us to over-emphasize one or two reasonably small or irrelevant similarities while ignoring the many falling knives that don’t recover.
Certainly, there has been some significant cost-cutting among tobacco companies that may well be copied by the major pharmaceuticals, but this has not been the main driver for the extraordinary growth in profitability over the last decade. Price increases have been of far more significance.
These companies are very fortunate to have customers who are addicted to their products and are therefore relatively price insensitive. It is unlikely that the pharmaceuticals have similar pricing power, particularly as they are in the middle of a nasty multi-year period when a number of their drugs come off patent and a large percentage of their revenues worldwide are provided by cash-strapped governments.
I am certainly not arguing against the belief that pharmaceutical stocks are cheap – we are overweight the sector ourselves – but find it difficult to see too many parallels with the tobacco sector.
Alastair Mundy manages a number of funds at Investec, including Managed Distribution, Special SituationsCautious Managed. The views expressed here are his own.