Pharma stocks to surprise in 2010 as market gets exciting

A STOCK that is safe, highly defensive and very boring is not exactly the sort of thing that you might be looking for in order to add excitement to your portfolio at a time when the world is emerging from recession and global equity markets are booming. <br /><br />But boring old pharma is back in favour for 2010, it would seem. Last week, strategists at both Morgan Stanley and UBS were surprisingly bullish on European pharmaceuticals as part of their 2010 outlooks. They see a distinct possibility that the sector will outperform the wider market.<br /><br />So what is the case for getting back into pharma? Firstly, both Morgan Stanley and UBS see the sector as attractively valued at the moment. On a relative forward price/earnings (p/e) ratio, the European pharma sector has recently traded at its lowest levels versus the wider MSCI index for the past 20 years. It is trading two standard deviations below its mean versus the MSCI on rolling one-year forward p/e. In 1993, when EU pharma last traded at similar levels, the sector proceeded to outperform the MSCI by 11.4 per cent per year in the following five years.<br /><br />UBS&rsquo;s head of pharmaceutical strategy Gbola Amusa says that the pharma sector&rsquo;s valuation has suffered from widespread sector rotation from defensive sectors into cyclical sectors, and from lingering concerns on US healthcare reforms.<br /><br />But pharma has also suffered from the consensus view that the sector&rsquo;s fundamentals are poor and that companies are under pressure in the medium term from patent expiries, tough regulations and a lack of new drugs. However, there are four good reasons to suspect that these will change and pharma will pick up next year, says Morgan Stanley&rsquo;s European equity strategist Ronan Carr. <br /><br />First, regulatory concerns are overdone and US reform has been largely priced in to the sector. Although they might have some negative impact on European pharma companies, the downside on earnings is expected to be less than 3 per cent. The US Food and Drug Administration (FDA) is also becoming more benign, Carr says, and more drugs have been approved recently. <br /><br />Secondly, the pharmaceuticals industry &ndash; which has typically been based in industrialised countries &ndash; is expanding. Indeed, Carr says that as healthcare spending is being ramped up in some markets, pharma could become a surprise play on emerging market growth. <br /><br />UBS&rsquo;s Amusa agrees, saying that a number of the bigger emerging market countries are undergoing state healthcare expansion and he expects that pharma spending could grow by two to three times the rate of local GDP growth. The large multinational pharma players are consolidating in emerging markets and are therefore growing faster than the market &ndash; 30-60 per cent annual growth is typical in China recently for pharma companies, says Amusa. Thirdly, big cap pharma has diversified into areas such as vaccines and branded generics that offer more visible and sustainable growth and profitability. <br /><br />And finally, there is a good chance that near-term prospects for the sector could be boosted by restructuring as companies refocus on research and development as well as cutting costs.<br /><br />Morgan Stanley strategists say they expect a broadening out in sector performance and a rotation into more defensive groups as fiscal and monetary tightening approaches and key indicators of cyclical growth start to plateau. You should look to mid-to-large cap pharma stocks, which are very cash generative and boast very strong balance sheets, says the bank. With pharma expected to outperform in 2010, spread betters might do well to get into the sector now before share prices start rising and those attractive valuations disappear. <br /><br />Sectoral spread bets offer diversified exposure so you don&rsquo;t have to lay yourself open to stock-specific risk. But if you want some individual stocks to amplify your returns, then UBS is particularly bullish on AstraZeneca, which in its analysts&rsquo; view is an outlier on valuation and cash generation and has some of the sector&rsquo;s most important 2010 catalysts. They also recommend buying London-listed heavyweight GlaxoSmithKline, based on its emerging market exposure &ndash; ideal for spread betters looking at a play on growth. <br /><br />But be careful when it comes to trading pharma stocks &ndash; their share prices (and those of their rivals) are likely to see sharp moves when the results of drug trials are announced. For example, next Tuesday, the AstraZeneca FDA advisory panel will meet to consult on Crestor Jupiter, a statin, which might result in an FDA endorsement or see it sent back to the drawing board. Betting on the result can be a good way to take advantage of volatility, but set your stop losses close just in case the decision goes against you. <br /><br />Safe and boring pharma is going to become a lot more exciting in 2010. <br /><br />Spread betters should be jumping into the sector while stocks are still priced attractively.