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YOUR MONEY-How to find value, as well as growth, in drug stocks

Source: Reuters - Tue, 10 Jun 2014 17:55 GMT
Author: Reuters
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(The author is a Reuters contributor. The opinions expressed are his own.)

By Conrad de Aenlle

June 10, (Reuters) - Drugmakers have become fond of one another.

The value of mergers in the industry was 20.9 percent higher in the first quarter than the fourth, reaching $44.9 billion, according to a PricewaterhouseCoopers report that predicts continued robust activity.

The wheeling and dealing has helped lure investors, judging by the double-digit percentage gains this year in many drug stocks, but it has stirred caution in fund managers with heavy exposure to the industry. With high stock prices and some takeover bids viewed as less prudent than others, don't get sidetracked by the prospect of further mergers, money managers say. Instead, they continue to focus on the basics: valuations, growth prospects and income.

A takeover bid that caused much consternation didn't even go through after AstraZeneca PLC said "no thanks" to Pfizer Inc. in April. The episode caused Eric Sappenfield, co-manager of the John Hancock Global Shareholder Yield Fund , to turn cautious on Pfizer, although he still owns some.

"The bid for AstraZeneca was a 180-degree turn," says Sappenfield, whose fund is a top performer over three and five years among world equity funds, according to Lipper, a unit of Thomson Reuters. "You have to trust management. The jury is out on what management is trying to do at Pfizer. The bid caught people by surprise."

Pfizer is the largest holding in T. Rowe Price Institutional Global Value Equity Fund, which ranks in the top quintile in returns over the last year among world equity funds, according to Lipper.

"They're very well managed, they're great at generating cash from their existing franchise, and they're skilled at deals," despite the failed attempt to woo AstraZeneca, says the fund's manager Sebastien Mallet. He likes Pfizer's valuation of 13 times estimated 2014 earnings and 3.5 percent dividend yield.

Three of the other top 10 holdings in the T. Rowe Price fund are large drugmakers, too. Overall, healthcare represents 16 percent of the portfolio. (The fund has a total expense ratio of 0.75 percent.)

"After strong growth in the 1990s, the drug industry "became complacent, with unfocused (research & development) and very little to show in their pipelines," Mallet recalls. "The stocks were cheap and controversial, so I bought a lot of them." In recent years, he contends, drug companies have become more efficient businesses, and their research efforts are improving.

One of his holdings, Novartis AG of Switzerland, swapped some of its assets in April for others belonging to GlaxoSmithKline PLC. Mallet expects the move, sort of a merger-lite, to allow the companies to play to their strengths - cancer treatments in Novartis's case.

A big draw of another holding, Teva Pharmaceutical Industries Ltd., is its cheap valuation of 11 times estimated 2014 earnings. Concerns about the imminent expiration of patents on its leading drug, Copaxone, a multiple sclerosis treatment, are "overblown" because the Israeli company is developing easier, less expensive, less painful methods of administering Copaxone that he expects to limit the appeal of generic versions.

Mallet describes another portfolio constituent, Johnson & Johnson, as "a sleepy company with fantastic assets that became more focused and started to have a better pipeline on the pharma side." At about 16 times estimated 2014 earnings, its valuation is in line with the broad market, but "it's a very high-quality company, solid as a rock," he says.

Sappenfield is less interested in value than growth, which he considers vital to a company's ability to pay and increase its dividend. He has a modest stake in Johnson & Johnson, which he admires for having "an abnormally high growth rate for the kind of battleship company they are."

PREDICTABLE PROFITS

Sappenfield prefers other drug stocks, though, including Novartis, Glaxo and two others in Europe, Sanofi SA of France and its Swiss counterpart Roche Holding AG. He favors them not just for their ability to grow but to do it reliably.

"Pharma companies generate a reasonably predictable stream of profits," Sappenfield says. "You want to see that consistency. That's why we're in the big guys. They're marketing machines with sustainable pipelines."

His fund has about a 9 percent stake in healthcare stocks - less than average - but he rates drug stocks highly while shunning other segments of the healthcare group, such as medical equipment providers and hospital operators. The John Hancock fund has a total expense ratio of 1.34 percent, according to Lipper.

Sappenfield isn't too worried about paying the right price for stocks, but he hates to pay the wrong price. He sold Bristol-Myers Squibb Co because it got too expensive, he says. "Expectations for some of their drugs were so outrageous that everything had to be perfect for Bristol-Myers to work."

Mallet expresses some valuation concerns of his own. Although his exposure to drugmakers remains high, it has come down slightly as price-earnings multiples have increased, and he expects to cut back further if the trend continues. But he still finds far more working for them than against them.

"They have refocused their business models and cut costs," he says. "The stocks are less cheap, but they still have good cash-flow generation and dividend payments."

(Follow us @ReutersMoney or at http://www.reuters.com/finance/personal-finance; Editing by Lauren Young and Nick Zieminski)

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