It has been some time since the pharmaceuticals sector was feted as the poster child for growth stock investors. If you turn on the news today, you are likely to hear all about the threats posed by Obamacare, European austerity, patent expiries as well as overblown fears that the well has run dry on new drug discovery. Misery loves company and people are prone to believe it if you beat the drum often enough, so that potential risks become accepted facts.
Following this prolonged period of bearish sentiment, we believe that investors should look again at this unloved sector in Europe. We have been saying for some time that the pharmaceuticals industry is far better than general perception would indicate. I would go further and say that pharmaceuticals may be the biggest example of positive mean reversion in the whole of Europe, and that we may be only part way into what may turn out to be a decade-long bull market.
We renewed our interest in European pharmaceuticals two to three years ago, when the major players had single-digit price/earnings ratios (having been as high as the 30s in the late 1990s). At that point, companies were starting to increase their contributions from sustainable franchises offering long-term revenue security: businesses such as animal health, nutritional foods and vaccines. Yet investors were still pricing in the possibility that companies would fail to come up with replacement drugs to generate future earnings.
Developing new medicines is the lifeblood of this industry, but this is no different from any other industry. Peaks and troughs are part of the natural rhythm and it is the fallow period from 1998 to 2006 – when fewer new drugs were reaching the market – that wrongly shaped current opinions. In reality, research and development (R&D) pipelines were not ‘running out of science’. In fact, recent research in the UK has shown that the number of drugs introduced each year has actually increased on average since the 1970s.
What is true is that industry and market factors have forced pharmaceuticals to adapt, by reassessing and redesigning their business models and diversifying into new growth areas. Commitment to R&D remains strong, but it is much more focused, leaner and efficient than it used to be. More attention is being paid to managing the lifecycle of drugs to maximise returns. Major manufacturers are also entering into the market for generic drugs, or cutting the cost of their post-patent expiry products to slow the erosion of revenues.
We firmly believe that the story for European pharmaceuticals remains intact, with many companies well positioned to deliver long-term sustainable earnings and priced at attractive entry levels for investors. Given these factors, we continue to increase our exposure to pharmaceuticals and healthcare in general now makes up between 30% and 40% of our portfolios.
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