Pharma Stocks: Is Re-rating On The Cards?

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

You just need to find it, invest in it, and persevere during poor performance. The former is relatively easier than the latter.

He is alright about what the investment is worth,

My next statement may confuse the traditional ‘buy and hold’ investor…

There is a belief in the market: buy good quality businesses and forget about them. Well, I believe that buy and hold doesn’t work. Leave cyclical sectors, it doesn’t work in FMCG either. The only constant in the market is sector rotation.

2003-2007 was the era of infrastructure and real estate stocks. Pharma and FMCG stocks rallied sharply due to the fall caused by the global financial crisis.

Post Covid, it was the chemical and diagnostic space that was the darling of the market.

However, in 2022, when things normalise, the abnormal valuations of these sectors will return to mean as earnings slow down.

Hence the focus shifted to value from development, where the public sector was favoured.

Stocks like NTPC, Coal India, Power Grid etc attracted strong interest from both retail as well as institutional investors. In fact, the barometer of PSU Sector Which is close to the all-time high level of the Nifty PSE index.

In the stock market, every sector is cyclical no matter how ‘defensive’ it may be considered. Pharma and FMCG which are considered to be defensive and ‘safe’ also have an element of cyclicality.

The question is, how do we find out which areas are most likely to elicit taste?

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

Let’s discuss the most unpopular sector right now and how its fortunes could turn around.

Pharma – the most unpopular field of 2022

Let’s take you to 2009…

India’s exports of branded generics grew at a CAGR of 16% from FY09-FY15. The domestic market continued its steady growth. This resulted in higher earnings and margin expansion.

Companies like Lupine and Sun Pharma went in for acquisitions in their ambition to fund growth. The re-rating of the valuation multiple led to a jump in share prices.

The right time to invest was 2009-2010 when the export business was looking promising. The 6 year period from 2010-2015 led to strong performance of Pharma sector as compared to Nifty.

The main reason for this was…

⦁ Strong revenue and profit growth.

⦁ Re-rating valuation multiples due to strong growth.

Some stocks like Sun Pharma, Lupine, Biocon, Strides, IPCA Laboratories have given strong returns during that period. After all, pharma was a sector where nothing could go wrong.

Well, something was wrong. The problem was in the valuation of these shares.

How can price to book value be top 10 companies in pharma sector be 6.5 times? Well, contrary to public opinion, pharma was also a cyclical sector, showing margins in 2016.

While margins were on an upward trajectory by FY2016, the shares peaked a year later before being reflected in fundamentals. Smart money knew that the era of margin expansion was coming to an end.

The purpose of this exercise was to show why evaluations are so important in detecting the end of a cycle.

From a fundamental point of view, the decade 2010-2020 was divided into two parts for the pharma sector.

First Half (2009-2015) – What Went Right

⦁ Rapid growth in exports due to new opportunities

⦁ Stable domestic business

⦁ Rising valuation

⦁ Domestic facing sectors were weak as the post-2008 recovery was underway.

Second Half (2016-2019) – What Went Wrong

⦁ Pharma companies acquire foreign companies at exorbitant valuations on the assumption of high export growth.

⦁ R&D expenditure was at its peak. Most of the free cash flow was wasted in R&D.

⦁ However, exports slowed down on pricing pressure with vendor consolidation in the United States.

⦁ Valuations were too high and had to be de-rated on slow growth.

The NSE Pharma index made a top in October 2015, till March 2023 the index was at the same level. No return for 7 years.

The question to be asked now is, ‘Where are we in the cycle?’

Low price to book the combination (subject to fundamentals) and 5 year profit growth should be low. This will signal a higher position to the upside when the profit comes to an end.

In the previous cycle, valuations were at 6-6.5x and at the bottom, the sector was a strong buy at 2.5-3x.

Look at these criteria when considering top pharma companies in india,

Disclaimer: This article is for information purposes only. This is not a stock recommendation and should not be treated as such.

This article is syndicated equitymaster.com