The global equities team at Invesco Perpetual has been adding to the unloved pharmaceuticals sector after a “toxic cocktail of increased risk” left companies at more attractive valuations. 
Investors have fallen out of love with the pharmaceuticals sector in recent years thanks to a growing risk of political interference in drug pricing in the US, high valuations and rising competition from cheap generic medicines.
FE Analytics shows the MSCI World Pharmaceuticals index has lagged the broader MSCI World by around 20 percentage points over the past five years because of these concerns, with the bulk of this underperformance coming in the last two years.
One of the major sources of these concerns is the ambition of US politicians to drive down drug prices. In the American Patients First: The Trump Administration Blueprint to Lower Drug Prices and Reduce Out-of-Pocket Costs report, published in May 2018, US president Donald Trump said: “One of my greatest priorities is to reduce the price of prescription drugs.
Performance of indices over 5yrs
Source: FE Analytics
“In many other countries, these drugs cost far less than what we pay in the US. That is why I have directed my administration to make fixing the injustice of high drug prices one of our top priorities. Prices will come down.”
John Botham, a product director on the global equities team at Invesco Perpetual, noted that the US market is the most profitable pharmaceuticals market in the world but added that Trump’s statement appears to present little short-term risk to either drug prices or the structure of the US healthcare system.
“It may come as a surprise to know that pharmaceuticals account for only 10 per cent of US healthcare spending and less in the UK and other countries with more socialised healthcare systems. For politicians in the US there may be easier wins to lower healthcare costs than pharmaceuticals,” he said.
“However, pressure for some reform to the US healthcare system is likely to continue to be a touchstone issue in US politics in years to come, and pharmaceutical prices will remain in our opinion a target for politicians.”
Prices asides, sentiment towards the sector has been impacted by other factors – including the rise of generic medicines and ‘bio-similars’ in particular.
Over the last 20 years, drug companies have developed very complex, highly effective treatments for certain cancers and immune disorders especially by using biotechnology to target these illnesses.
However, many of these treatments are now approaching the end of their patent lives and competitors are able to produce copies at a much cheaper price that still have a very close effect to the original, more expensive drug. Furthermore, regulators appear to be happy to approve these generic versions and doctors are willing to use them, which dents the profit expectations for many industry players.
That said, Botham argued that the pharmaceuticals sector still has some positives that can overcome the risks highlighted above, although Invesco Perpetual is not yet full-on bullish over the sector.
Healthcare spending by type of service or product (%)
Source: Invesco Perpetual, Credit Suisse, as at 22 Jun 2018
“We all want to live longer and better, society still supports investment in new treatments and seems willing to pay for genuinely innovative treatments,” he said.
“Furthermore, increased wealth in emerging markets is enlarging the market for pharmaceutical products. Developed market populations are ageing; there is therefore a secular increase in demand for the industry’s medicines.”
Botham also pointed out that pharmaceutical companies are working hard to improve the productivity of their research and development activities, they are using new technologies to focus more quickly on potentially interesting new compounds and regulators are taking “a more constructive approach” to new products.
Other positives include “genuinely interesting areas of research”, such as the exploration of drugs to stimulate the immune system to treat cancer or more attention on the need for new medicines to deal with Alzheimer’s and other forms of dementia.
With these plus points in mind, Botham asked if “the valuations we find in the sector now discounting too much of the bad news and not enough of the good?”
The £1.5bn Invesco Perpetual Global Equity and £951m Invesco Perpetual Global Equity Income funds, which are based around a bottom-up approach, were overweight pharmaceutical companies until 2014 but moved to an underweight position because of high valuations and growing political risks.
But the funds have started to add pharmaceuticals exposure more recently, although they still remain underweight versus the benchmark. “Valuations have corrected significantly and the sector both in the US and Europe is trading below its historic averages,” Botham said.
“We can find companies trading at a discount to the present value of cash flows generated from existing products; effectively the pipeline is for free. On other measures, as well, we can see the sector offering free cash flow and dividend yield premium to the market.”
Both Invesco Perpetual Global Equity and Invesco Perpetual Global Equity Income own German pharmaceutical firm Bayer as it is considered to be a high quality and well-managed business, which fell out of favour with the wider market after a period of negative earnings momentum. However, Invesco Perpetual believes this is “largely transitory”.
Sector multiples have drifted below historical average vs S&P 500 for biopharma
Source: Invesco Perpetual, Credit Suisse, as at 22 Jun 2018
Invesco Perpetual Global Equity also holds US pharmaceutical firm Allergan, whose portfolio of non-reimbursable medicines mean it is less exposed to pricing pressures from political agendas, and US biotech name Biogen, which fell after disappointing sales of its key multiple sclerosis drug but also has a potential valuable Alzheimer’s disease pipeline.
In the Invesco Perpetual Global Equity Income fund, healthcare holdings tend to have more proven products, stronger cash-flows and higher dividends. Two holdings include US biopharmaceutical firms Amgen and Gilead Sciences as well as Swiss-based majors Roche and Novartis.
Summing up the Invesco Perpetual global equities team’s outlook for the pharmaceuticals sector, Botham said it remains “firmly astride the fence” even though the above opportunities have opened up.
“Whilst we note the much more attractive valuations on which many companies now trade, and we have increased our exposure to certain companies where we believe risks to profits growth to be overdone, we remain modestly underweight relative to the benchmark,” he explained.
“Despite some positive longer-term secular drivers, the risks to pricing in the US, which remains the ‘honeypot’ for the sector are real and are political in nature and will not be resolved in the short term. New product innovation is not yet sufficient to overcome this risk in the case of many companies in our universe.”