Are Bitter Days Over for Pharma Stocks? 

Hi guys, this is Aditya Vora here...

It is always said that there is a bull market in some part of the world.

In fact, if you look at the stock market, there is also a bull market in some or the other sector.

The genius lies in finding it, investing in it, and staying put during times of underperformance.

The former is relatively easier as compared to the latter.

That is precisely what value investing is...

My next statement might confuse the conventional 'buy and hold' investors.

There is a notion in the market about BUY good quality business and FORGET them.

Forget cyclical sectors, buy and hold doesn't even work in FMCG.

The only constant theme in the market is sector rotation.

If you look at the stock markets over the past 20 years...It has always been a market of sector rotation.

While 2003-2007 was the era of infrastructure and real estate stocks, the bust which followed than due to the global financial crisis led to the sharp rise of pharma and FMCG stocks.

Post Covid in 2020, it was the chemical and diagnostic space which was the darling of the market.

However, in 2022, when things normalised, the abnormal valuation of chemical and diagnostic sector reverted to mean as earnings slowed down.

In 2022, the focus shifted to value from growth, where public sector stocks were preferred.

Stocks like NTPC, Coal India, Power Grid and the likes attracted strong flows from both the retail as well as institutional investors on account of superb value. In fact, the barometer of PSU sector which is the Nifty PSE index is close to an all time high.

What I am trying to highlight is that every sector is cyclical no matter how defensive it is perceived.

Pharma and FMCG which are touted as defensives and safe also have an element of cyclicality in them.

The question is how do we find out which sectors are likely to get in to flavour?

The simple answer is valuations, and the more complex answer is industry trends.

Let me give you an illustration about the most unloved sector now and how fortunes can change for this sector.

I am talking about the Pharma Sector

Let me take you back to 2009 which was where India started getting recognition as the pharmacy to the world when it came to branded generics.

While the innovation was done in developed countries, the problem there was the cost factor and the patents to new drugs.

This kept the prices of branded drugs very high becoming increasingly unaffordable for the American population.

The fix was that as the branded drugs go off patent, companies in India and China started making the generic version of those drugs at a fraction of the cost.

The key factor was cheap labour along with expertise in India and China.

In fact, coincidently even the domestic pharma market in India was doing well.

For any pharma company, India business was a cash cow while the USA and Europe business was high growth and high margin business which pushed ROCEs and ROEs of the companies.

India's exports of branded generics grew by 16% CAGR from FY09-FY15 while domestic market continued its steady growth. This led to higher earnings and margin expansion during that period.

The scenario was a perfect goldilocks scenario where big pharma companies like Sun and Lupin became cash generating machines.

I am sure you know, when companies have a lot of cash, they generally go for acquisitions to fuel inorganic growth.

This is exactly what happened...

Companies like Lupin and Sun Pharma went for acquisitions in their ambition to fund future growth.

Lupin acquired Gavis at high prices while Sun Pharma eventually acquired Ranbaxy.

During 2009 to 2015, while the stock prices zoomed, the valuation multiples too re rated.

The time to invest in pharma stocks was 2009-2010 when export business was looking promising. The pharmaceutical sector in 2008 was at the same place the IT sector in the mid-1990s.

The 6-year period from 2010-2015 led to strong outperformance of the pharma sector as compared to the benchmark Nifty.

This was primarily on account of

1. Strong revenue and profit growth
2. Re rating of valuation multiples led by strong growth.

Stocks like Sun Pharma, Lupin, Biocon, Strides, IPCA laboratories to name a few, gave stellar returns during that period.

After all, pharma was the defensive sector where nothing could go wrong.

Well, the problem was in the valuations.

The pharma sector during 2009 was available at 2.8-3 times price to book valuations. Now I know it is easy to say that the right time to buy was in 2008 or 2009 when the valuations were relatively cheap.

I am sure, no one can buy stocks or sectors at the bottom.

My point is, even if you bought the pharma sector stocks between 2010 to 2013, you were buying at reasonable valuations. In fact, during the 2012 period, pharma was already a discovered story.

However, the valuations started accelerating ahead of the fundamentals. While margins and return on equity for pharma stocks were rising, the valuations were rising at a faster pace.

So much so that the price to book of some pharma companies were at 6.5 to 7 times.

How on earth can you have a price to book value of the top 10 companies in the pharma sector at 6.5 times?

This is the multiple which we give FMCG companies.

It was at peak valuations where quarterly numbers of pharma companies started moderating and eventually plummeted.

Now, when 1 or 2 quarter numbers are bad people ignore as its difficult to understand the peak.

Eventually, margins, sales, profits everything moderated leading to massive de rating in the multiples.

Just out of context, let me tell you how de rating happens.

First earnings derate, then multiple derates. What happens is that as earnings or EPS is declining, optically the valuations looks high despite multiple contraction.

For pharma sector, while margins were on an uptrend till FY16, the stocks started peaking out before it was reflected in fundamentals a year later.

The point of back testing data was to show how valuations are the most important parameters for cycles ending.

From a fundamental perspective, the decade from 2010-2020 for the pharma sector was split in to two halves.

First Half (2009-2015) is what we call What Went Right

• Booming export growth on new opportunities
  
  Steady domestic business
  
  Valuation comfort
  
  Domestic facing sectors weak as recovery was underway post GFC.

Second Half (2016-2019) is What Went Wrong

• Pharma companies acquired overseas companies at exorbitant valuations on assumption of high export growth.
  
  R&D expenses were at their peak. Most of the free cash flow was burnt in R&D.
  
  However, exports slowed down on pricing pressure in the USA along with vendor consolidation.
  
  Valuations were too high and had to de rate on slowing growth.

The NSE Pharma Index made a top in October 2015... the index as of March 2023 is at the same level.

No returns for 7 long years.

So friends, the question to be asked now is ... Where are we in the cycle?

I have curated a list top pharma companies and compared valuation multiples with last 5 years of profit growth.

The combination (subject to fundamentals) should be lower price to book and lower 5-year profit growth, indicating higher room for upside when profits come by.

The last cycle, valuations peaked at 6-6.5 times while the sector was a strong buy at 2.5-3 times.

While valuations are moderate, if earnings start to kick in, this sector will re rate.

Let me end this video by telling you how psychology works in the stock market.

When everybody dislikes a sector, that is precisely the time to go overweight on it, obviously subject to fundamentals changing.