Sector Flash: Pharmaceuticals

Walker Smith, Jr. (better known as Sugar Ray Robinson), perhaps the greatest prizefighter to ever live, once famously said: “To be a champ, you have to believe in yourself when nobody else will.”

At times, an apt metaphor for investing. Seeing something differently or unappreciated by others can be paramount to outperforming markets. And now, it seems few investors still “believe” in Pharmaceuticals stocks, given the industry’s seemingly serial underperformance. In fact, Pharmaceuticals enjoyed only a brief period of outperformance over the last 10 years—during the 2008 bear market.

Exhibit 1: Relative Performance of S&P 500 Pharmaceuticals Stocks to the S&P 500

Source: Thomson Reuters, as of 10/26/2011.

Major drivers of this long period of underperformance included fears of looming patent expirations, a storm of regulatory uncertainty and years of disappointing pipeline development.

But a few drivers aligning now seem likely to benefit Pharmaceuticals. First, pharmaceutical firms tend to be categorized as “big growth” stocks, and it seems likely we will eventually experience a gradual shift from small value leadership to big growth in the coming years, as is fairly typical through market history.

More specifically, there’s a likely forthcoming rapid decline in patent expirations and positive pipeline development. What’s more, that decline is mostly overlooked or downplayed by investors. But that’s far from the only tailwind I see for Pharmaceuticals stocks.

Balance Sheet Strength

As shown in Exhibit 2, globally, Pharmaceuticals firms are cash rich. Record cash on hand gives Pharmaceuticals firms the needed financial flexibility to increase R&D, buy back shares, distribute dividends and pursue strategic acquisitions.

Exhibit 2: Top 75 Global Pharmaceuticals’ Corporate Cash as a Percent of Market Cap

Source: Thomson Reuters, as of 10/26/2011.

Ultra Cheap Valuations

Poor sentiment on Pharmaceuticals stocks has depressed valuations to levels implying very little growth moving forward. However, Emerging Markets growth and new drug development should help Pharmaceuticals exceed these low expectations—simply, forward valuations (displayed in Exhibit 3) do not, in my view, seem to be a great reflection of the opportunities ahead. Rather, they’re more reflective of the fears behind.

Exhibit 3: MSCI World Pharmaceuticals Valuations

Source: Thomson Reuters, as of 10/26/2011.

Combined, it’s key to be aware of both fundamental and sentiment factors surrounding either the entire market or an industry. With Pharmaceuticals, it just doesn’t seem sentiment has moved beyond past old fears to focus on the true reality now—and the opportunity ahead. For that reason, there is an opportunity here—one best harvested by “believing” in Pharmaceuticals before the crowd does.