The top 10 western European pure play pharmaceutical companies generated sales in excess of €226bn in 2016, combined net profits of €41.2bn and their market capitalisations total some €892bn. There’s no question that this industry plays an important role in corporate Europe and it represents a hefty portion of many major stock market indices. 
The sector has enjoyed good performance year to date, with the Bloomberg pharmaceutical index returning 14.50 per cent against the 10.49 per cent for the Bloomberg European 500 index. Despite this rise the sector still remains well off its 2015 highs, following dismal performance in the second half of that year and throughout 2016.
However, since its most recent nadir in 2009, the sector has handsomely outperformed with the Bloomberg Pharma Index delivering a total return of 232 per cent against 173 per cent for the BE500 Index .
There is a sound underlying rationale for this performance. The pharmaceutical industry is capitalising on an ever growing demand for life-saving products and years of expensive research are being rewarded by profit margins few other industries could hope to rival.
But, as the poor performance in 2016 demonstrated, it’s these very returns that make the industry potentially dangerous to invest in. The issue of pricing is a central concern, especially in the all-important and highly profitable US market. Thanks largely to a somewhat convoluted pricing system the US drugs market has always been lucrative, as the charts below demonstrate.
Pricing of Crestor and Gleevec
Source: Bloomberg
Many European players are heavily exposed to the US market, with sales from the region accounting for over a third of turnover. Little wonder then that when the spectre of price control was raised during the 2016 US presidential election, these stocks took a universal hit.
The industry’s defence is that today’s high prices are a necessity if tomorrow’s new molecules are to be supported by expensive R&D programmes. This argument is puzzling, not least because there’s a clear demarcation of pricing levels between Europe and North America. It is difficult to justify why one side of the Atlantic should subsidise the other’s research programmes.
A recent meeting with a top 10 global pharmaceutical also brought the priorities of these corporations into stark reality.
The company boasts of a quarterly R&D spend of €322m in Q3 2016, which may be admirable, but travel further down the P&L and you will find €623m spent on sales and marketing. If we aggregate these two expenses for the top 10 European players by market capitalisation, we find that although R&D totals a handsome €37.8bn for 2016, and this is dwarfed by the €64.5bn spent on selling, general and administrative expenses.
Is it the lavish sales channels of these companies that really necessitate the ever higher pricing? The investment implications could be severe if politicians once again choose to latch on to such numbers.
Another well-known European pharmaceutical company attempted a robust defence of their pricing strategy, pointing out that between 2001 and 2016 a 353 per cent increase in the list price of one of their drugs turned into only a 36 per cent net price increase once rebates had been taken into account. If such a murky and misleading method of pricing is the best defence they can come up with, it provides much fodder to an already alarmed queue of payers, politicians and patients.
This issue has always existed in one form or another, so it’s not in its own right a reason to avoid the pharmaceutical sector. That said, should political, regulatory or public finance pressures bring it back to the forefront of debate, the sector’s outperformance may once again come to a shuddering halt.
Hugh Cuthbert is manager of the SVM Continental Europe fund. The views expressed above are his own and should not be taken as investment advice.