06 May 2021
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A version of this article first appeared in Citywire Wealth Manager on 28 April 2021.
The biggest issue facing the world in the past 12 months has been health-related, yet many of the pharma giants have had a difficult year. AstraZeneca offered to produce Oxford University’s Covid vaccine at cost. Its reward has been abuse and a share price that has fallen nearly 6% in a year (against the FTSE All Share, up c.19%).
Pfizer has done better – up nearer 13%, but this is in the context of American markets that have risen by c.45%.
These two are not outliers. The forward P/E of the MSCI World Healthcare Sector relative to the MSCI All Country World index is almost as low as it has been since the great financial crisis. What is going on?
As the vaccine programme rolls out, many might think this a good time to invest in healthcare. The speed with which the various vaccines have been developed highlights the exciting possibilities for Big Pharma of next-generation gene sequencing. The Oxford University vaccine was designed within a few days of the DNA sequence arriving from China. Within weeks the scientists had created samples in the lab for trials.
Similar science is helping pharmaceutical companies study the gene sequences of different cancers and develop more effective treatments using the immune system to effect its own cure. Some of these are already big-selling drugs, including Merck’s Keytruda, which has revolutionised treatment of skin cancer and some breast cancers. It looks expensive but has less violent side effects than chemotherapy or radiation, which is better for patients and can reduce overall costs of care.
It has been difficult to conduct clinical trials during Covid, so we expect a rush of similarly exciting drugs next year. Not all drug companies will benefit. In Europe, Swiss firm Roche made some wise strategic acquisitions a decade ago in this cutting-edge area of science. Other European pharmaceutical companies seem rather short of prospective new products. When companies pay out big dividends instead of investing in research and development, I worry about their long-term pipeline of drugs.
So we like some pharma companies, and particularly Roche and Merck. Yet we have sold Merck recently. We may buy it again later, but for now it is being weighed down by the shift to the left in American politics. Bernie Sanders has long argued that Big Pharma is ripping people off, and it is easy to see why. Research suggests that Americans pay on average two-and-a-half times more than those in most developed countries for their drugs.
In March, Sanders who now has a senior position in the Senate, introduced three bills designed to peg back prices. If passed they will allow Medicare and Medicaid to negotiate what they pay. At the moment the US is the only developed country to allow Big Pharma to charge full ‘list prices’ even though the system then has numerous discounts. Sanders wants drug prices paid in the USA to be benchmarked against prices paid abroad and also wants to make it easier for Americans to import drugs – prices in Canada are much lower.
There are some Democrats who feel that any sort of state-dictated pricing would be too left-wing for them. So the legislation may be watered down. But there is serious pressure on drug prices.
The companies likely to be worst affected are those that produce popular treatments for the most common health problems – like diabetes, asthma and rheumatoid arthritis. In aggregate these weigh most heavily on budgets and so will be first in line for tough price negotiation.
It has always been difficult for pharmaceutical companies to justify the profit margins on individual drugs, but for every drug that succeeds you have to pay for many more that fail. You will have noticed that while the science behind the Covid vaccines is advanced, it is not exclusive to any one pharma company, which is why several apparently effective versions were quickly discovered. Without exclusive drugs to licence, the traditionally high margins may come under even more pressure. On the other hand, the new approach to designing treatments may mean fewer products prove to be dead ends.
Though we are cautious about Big Pharma, excitement about the scientific response to Covid does still manifest itself within our portfolios. The healthcare field where we see most dependable growth and profits is diagnostics and testing.
We like scientific equipment makers, such as Thermo Fisher and PerkinElmer, which have been beneficiaries of Covid testing. They are on higher multiples (30x and 20x historic earnings respectively and both yield a parsimonious 0.2%).
Prices have dipped recently, which some might see as a buying opportunity. Wall Street thinks Covid testing has collapsed and we will soon not need it to continue.
That feels premature – as personal experiences may confirm. Even if it is not, modern healthcare will have an increasing requirement for complex testing. We are at the beginning of a wave of new tests based on the latest breakthroughs in biochemistry and a deeper understanding of how diseases progress. People will have their whole genomes analysed to see what diseases they are likely to get, what they need to avoid and what ailments they should screen as they age.
We will see more testing within the NHS to give doctors more data, which should enable speedier, more effective diagnosis and hospital admission and reduce misdirected expenditure, treatment and time.
Though scientific supplies companies (in the main a handful of multi-nationals quoted on the US market) still look expensive, they have strong top-line growth, fat margins and a lot of repeat business. They supply the testing equipment quite cheaply to hospitals and then sell the reagents and other materials at a more comfortable margin. So they are highly cash-generative.
It seems ironic that the world’s biggest pharmaceutical companies should find themselves facing the greatest pressure on pricing and profits at the point when they have best demonstrated their value to society. I have some sympathy for them. I am not sure that this price purge will be beneficial for us all in the long run, but I do not see Bernie Sanders dropping the issue easily. He has waited 30 years to tackle it, since first becoming a Representative of Vermont in 1991.
We look for tailwinds, and try to avoid headwinds. When the weather changes we may return to our favoured drug companies. For now we will stick with our emphasis on testing.
Simon Edelsten is co-manager of the Artemis Global Select Fund and the Mid Wynd International Investment Trust.
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