Drug money: ­­Is there any life left in the pharmaceutical sector?

 
Luke Graham
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For some, investing in pharma is seen as too high-risk and best avoided (Source: Getty)

Healthcare is big business, and pharmaceuticals have done well by investors. But is there any life left in this sector, or is it about to flatline?

The industry has come into sharp focus following news that Japan’s largest pharmaceutical company, Takeda, is considering a takeover of UK-listed drugmaker Shire.

In fact, shares in Shire jumped more than 16 per cent on the announcement – an indication of how attractive the proposition is. “Following Shire’s acquisition of the Baxalta back in 2016, the group has strong positions in several attractive markets,” says Nicholas Hyett, equity analyst at Hargreaves Lansdown.

Sales of new drugs are rising rapidly, and major patent expiries aren’t scheduled until the 2020s, Hyett adds, pointing out that the labs are looking productive, which should secure revenue streams for the future.

The latest drug discoveries can become lucrative cash cows

However, Shire is not without risk.

The company’s stock price is currently valued lower – largely because of a $19bn debt build-up, which is weighing on the balance sheet following the Baxalta deal.

Read more: Shire looking fit as sales rise after its $32bn takeover of Baxalta in 2016

The Hargreaves analyst warns that this debt is equivalent to about three years of earnings – which will soak up cash for years to come.

“There’s also the looming threat of competition in the important haematology business, which accounts for $3.8bn of annual sales,” Hyett adds.

This pressure on Shire’s valuation may explain why Takeda has decided to swoop in on the company.

If it goes ahead with the acquisition, Takeda would become a global leader in the sector, gaining traction in the US – which is the world’s largest pharma market, according to Jonathan Wright, a senior manager at Fidelity.

The US is a particularly lucrative healthcare market due to its ageing population, which needs to manage various medical conditions, from diabetes to dementia.

“For some, investing in pharma is seen as too high-risk and best avoided,” warns Wright. “In several ways this is true, especially for smaller drug makers undergoing clinical trials with no clear outcome of whether they’re onto a winner, or those with drugs coming to the end of a patent, knowing the market will be flooded with a cheaper alternative.”

However, there are significant rewards for successful companies, as the latest drug discoveries can become lucrative cash cows, especially in markets with high demand, such as oncology and pain relief.

“This can mean a regular and growing dividend which is very attractive for pension companies or equity income funds in this era of low interest rates,” the Fidelity manager adds.

Total returns from healthcare equity funds averaged 12.75 per cent over one year, according to Morningstar data. That’s better than the 7.73 per cent average total returns achieved by global real estate equity funds, or 8.52 per cent by natural resources funds.

However, this return is way off the 25.99 per cent achieved by tech funds.

Investors should also bear in mind that growth in the pharma sector is expected to slow in the coming years. For instance, experts at ratings agency Fitch predict that the US market will see growth decelerate to somewhere between five and seven per cent until 2020, while Europe’s market will grow by just two to four per cent.

There are several reasons for the expected slowdown.

First, technology is expected to disrupt the sector, and big tech players are entering the scene – billions were wiped off healthcare stock valuations earlier this year on news that Amazon was working on a not-for-profit enterprise to try to reduce healthcare costs.

“Like many industries, big data, artificial intelligence and other digital innovations promise to radically alter the way things are done in pharma, from the discovery of drugs through to their clinical development, assessing their real world effectiveness, and determining their value,” says Eleanor Malone, editor in chief of Pharma Insights Europe.

The other reason is pricing pressure. Generic drug alternatives are entering the market, undercutting the profits of more expensive medications.

High drug prices were also a major topic during the 2016 US presidential election as President Trump promised to drive down drug prices. This price pressure is certainly a cause for concern for the sector.

However, there is still the potential for growth in pharma.

Demographics suggest that the world is ageing and getting richer, meaning a growing market for drugs, and breakthroughs will lead to new drugs that will address serious medical conditions. Meanwhile, Trump’s tax policies could boost the sector and lead to further mergers and acquisitions as US firms repatriate cash.

“Big pharma stocks have traditionally been safe bets for dividend yields,”says Malone. If anything, she says the trend is likely to increase as US firms return some of their large offshore cash piles to shareholders.

Despite pricing problems and the encroachment of tech firms into pharma’s territory, the outlook is healthy for the sector.

The best firms to invest will be those taking a proactive approach to innovation, while also embracing new digital and data strategies.

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