Worst is Over for the Pharma Sector, What investors Should Do? | 22 July, 2019

Retail investors prefer to invest in stocks, sectors and themes whose recent performance tends be good and avoid those with poor recent records, expecting their respective good and bad runs to continue forever. This is a flawed strategy. The BSE Healthcare Index has fallen 18% over the past three years and the pharmaceuticals sector is in doldrums now. Its paltry 2% compound annual growth rate over the past five years is another reason why investors have been avoiding this sector. However, experts advise that the best time to start accumulating a sector is when it is in trouble and its valuations are cheaper.

When it comes to the pharma sector, there is no concern on the domestic front and the domestic pharma growth story is intact. “Domestic pharma business is doing well and despite the increase in its base, this segment is expected to report a good growth in 2019-20 too,” says Pankaj Pandey, Head of Research, ICICI Direct.

The overseas market though, especially the US, is a different story altogether. The enquiries, observations and warning letters from the US Food and Drug Administration (FDA) have had an adverse impact on Indian pharma exporters for the past 3-4 years.

However, things have worsened in the recent past, especially after the sudden resignation of the US FDA commissioner in March. Since his resignation, the regulator has turned excessively cautious and the frequency of warnings has increased, but experts say that its recent actions are not a big issue. “This sudden increase in US FDA observations is applicable to all global companies and not just Indian companies,” says Surajit Pal, Senior Analyst, Pharma, Prabhudas Lilladher.

Promise of a turnaround

The pharma sector has seen a sharp fall in earnings growth over the past few years. However, most experts we spoke to believe that the worst is over for the pharma sector and its fundamentals are expected to improve gradually. “Financial year 2019-20 will see consolidation in the pharma sector (earnings will not fall further) and positive earnings growth is expected to happen from 2020-21,” says Pankaj Murarka, Fund Manager, Renaissance Investment Managers.

Steps taken by the Indian pharmaceutical companies to reduce their costs should improve earnings growth. “Indian pharma companies have learned from the tough times. They have rationalised their costs and are also selective in their new launches now,” says Pandey.

Since the stock market reacts well in advance to any turnaround story, investors need to get in early. “From a positional perspective, one can buy pharma companies selectively now,” says Pandey. Proper selection is critical. Before the sector got into trouble, the Indian pharma companies were minting money selling generic drugs in the US. However, it won’t be prudent to bet on past winners because of the structural change happening in the sector.

For intance, India’s generic US exports story is almost over and it’s best to look at other segments. “Competition from other countries is increasing in the generics space. So, Indian companies have to concentrate on niche segments now,” says Dilish Daniel, Pharma Analyst, Geojit Financial Services. Murarka concurs with this view: “Indian companies have to move up the value chain now. So, investors should concentrate on companies that have already invested in developing complex drugs.”

Some large-cap companies such as Sun Pharma have made significant investments in developing complex drugs for their export markets. However, this has been partly priced-in by the market, and that explains why Sun Pharma’s upside potential over the next one year is just 12%. The upside potential is measured on the basis of the average recommended price by analysts and the stock’s current market price. The good news is that some mid-range companies with upside potential of over 20% are still trading at reasonable valuations.

Don’t go overboard

Investors need to be cautious and not go overboard on the sector. As explained earlier, there has been a sudden increase in the number of letters to the pharma companies from the US FDA and this trend is likely to continue over the short term, even after the US FDA gets a new commissioner. This also means that investors should be able to bear short-term volatility.

The ET Pharma Index has also underperformed the Sensex by 13% during the past year. So, only investors who can withstand such short-term pain and are willing to stay invested for the long-term may consider this sector. We have shortlisted five promising pharma stocks for such investors. One of which, Biocon, is also our pick of the week and has therefore not been analysed here.

(Source: Economic Times)