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Buy Big Pharma By All Means, But Spread the Risk

Posted
10/21/2013 10:48:00 AM
By: Martin Tillier
Referenced Stocks:LLY;MRK;PFE;XPH

Over the last five years there has been no shortage of people predicting doom and gloom for the big, multi-national pharmaceutical companies. The stocks were bound to be in trouble, the logic went, as patents expired on some blockbuster medications and an emphasis on cutting costs in healthcare put pressure on pricing. The worst predictions of disaster have been proven to be inaccurate. The big companies have survived and investors have seen positive returns, but on a relative basis, they have not been stellar.

Over that five year period Pfizer (PFE) is up 76%, Eli Lilly (LLY) is up 45% and Merck (MRK) has gained 50%. As I said, these are decent returns, especially when you factor in dividend yields of 3.15%, 3.95% and 3.69% respectively. Even so, in the light of a 77% appreciation in the S&P 500 over that time, the sector as a whole has underperformed.

A large part of that is due to the last year. While the S&P has had a good year (+19.7%), PFE (+17.2%) is the only one of the three to show gains at all. LLY (-7.9%) and MRK (-2.8%) have had a tough time, despite beating earnings estimates consistently.

Those earnings beats would indicate that conventional wisdom has taken over, and analysts’ expectations for big pharma are, if anything overly pessimistic. When expectations are low and profits keep rising, something has to give.  

This situation, combined with the firms’ resiliency and continued profit makes me believe that a strong case can be made that over the next few months large pharmaceutical companies, in general, and these three in particular, could prove to be worthwhile investments. Globally, healthcare spending is always under pressure politically, but as the world grows richer people still see their health and longevity as something worth spending money on, and total spending keeps growing, fueled largely by growth in emerging markets. A 2010 survey by PriceWaterhouseCoopers estimated that from that point, total global healthcare spending would increase 50%, to $71 Trillion by 2020.

But, are the big companies best poised to benefit from that? There is no doubt that pipelines at major firms are far from bursting with innovative new drugs, but their distribution networks ensure that they remain as big players.  Most of the innovation seems to be coming from smaller, more nimble bio-tech firms and the tactic of the big boys seems to be “let them take the risk, and then use our vast pools of cash to buy them.” Given this, buying the right small guy would probably be a better tactic for investors, but that is not as easy as it sounds. Retail traders and investors don’t have the time needed to effectively research the pipelines and trial results of the host of diverse biotech companies that exist and make an informed decision.

So, you would like to buy big pharma, but don’t want to miss out on the chance of great returns from smaller bio-tech companies. In a situation like this, diversifying is key, but doing it yourself is not practical. Apart from the massive amount of research needed, trading costs on multiple investments can quickly become prohibitive. This is where an ETF comes in.

 

The above is the chart for the SPDR S&P Pharmaceuticals ETF (XPH). This fund uses the S&P Pharmaceuticals Select Industry Index as a benchmark. This index, and therefore the fund, includes the big companies, but has a significant weighting of small and medium cap companies in the sector.

Pharmaceuticals is generally a volatile sector, where risk is ever present, but if you want decent returns over time then you have to embrace that risk, not shy away from it. XPH has demonstrated that, with 189.8% appreciation in the same 5 year time span as the big pharma companies individually have struggled to keep pace with the broader market.

In short, then, I believe that the big boys may outperform in the coming months as low expectations by traders and analysts meet growing healthcare spending, but you cannot ignore history. A look back over 5 years tells us that, even if the big, multi-national firms do benefit as expectations catch up with reality, broad exposure gives a better chance of success.

XPH has come a long way in the last half a decade, but for those looking for exposure to the global growth in pharmaceutical spending, it may still be the best bet.