We adhere to the theory of mean reversion in our management of the portfolio. Three years ago, pharmaceuticals stocks were out of fashion and valuations had fallen to a very low level. The market, however, was overlooking the fact that pharmas had a long-term growth story ahead of them. Peaks and troughs are part of the natural rhythm in any industry and it is the fallow period from 1998 to 2006 – when fewer new drugs were reaching the market – that wrongly shaped current opinions.
Since then, companies have diversified into broader, more sustainable revenue streams through non-core pharmaceutical treatments, low-cost generics and emerging markets opportunities that are less dependent on patent protection or research and development. Technological progress has enabled firms to launch new medications for widespread diseases such as cancer and Alzheimer's. At the same time, demographic developments and growing demand in emerging economies has fuelled demand for treatments.
Sanofi and Roche are two examples of companies we favour in the industry:
French healthcare company Sanofi’s risk/reward profile remains attractive, given the positive outlook for the firm’s diabetes franchise, particularly Lantus, the insulin product, consumer health products and opportunities for growth in the emerging markets. Around 35% of Sanofi’s business comes from emerging markets where more medically immature markets are leading to strong uptake of healthcare products. The company’s broad earnings base could be a benchmark for any industry, with sales diversified by geography (US: 35% / EU: 24% / EM 32%/ ROW13%, 2012 figures) and division. The company’s sales are also well-balanced amongst government expenditure and private consumer expenditure. Net debt is significantly below target of €10 billion, so the balance sheet is strong and the company enjoys positive net cash flow. Investors can look to a healthy dividend yield, currently 3.7%, which is expected to rise next year by around 10% and there may even be potential for share buybacks. The company currently trades on a 1-year forward price/earnings ratio of around 13.5.
Swiss pharmaceuticals and diagnostics company Roche is a core long-term holding for us, reflecting our belief that the company is only partway through a multi-year re-rating. Sales have continued to grow at an impressive rate, driven by Roche’s headline cancer treatments Heceptin and Avastin, amongst others. The firm’s strong pipeline of potential new drugs, continued expansion of its diagnostics operations, and growing emerging markets presence should help Roche to grow earnings. Roche trades at a premium to some of the other pharmaceutcials but this reflects the quality of its products. A dividend yield currently of more than 3%, trading on a price/earnings ratio of 15 does not seem unreasonable for a company that is forecast to grow earnings by 7-10% per annum over the next few years.
Other investors have begun to discover this trend and the valuations among pharmaceuticals have risen but not to the extent that they are overvalued. In fact, we believe the sector is in the midst of a long-term upwards re-rating.
By John Bennett, Director of European Equities at Henderson Global Investors