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Pharmas market

Neil Woodford is spreading the word on undervalued pharma but not everyone agrees, says Chris Salih

Invesco Perpetual income manager Neil Woodford has banged the drum on pharmaceuticals, declaring it the most attractive time to invest in the sector during his fund management career.

Compared with the likes of mining companies, which have seen prices soar, pharmaceuticals have taken a back seat in recent times as fund managers have looked to recover from the credit crunch.

Woodford believes there are massive opportunities as the market has misread the fundamentals of pharma stocks. He says he is likely to take the weighting in his £7.9bn income and £10bn high income funds from 25 to more than 30 per cent.

Speaking at the Fund Strategy Investment Summit in Austria, Woodford highlighted AstraZeneca and Roche as two examples of stocks in the sector that are strongly undervalued.

Woodford says AstraZeneca will spend $50bn on research and development in the next 10 years and analysts are assuming in their forecasts you will get nothing back. He points to one analyst in particular who expects the company, which has a $65bn market cap and $4bn of net cash, will create $134bn of free cashflow after tax in the next 10 years.

He says: “What the analyst is assuming is that this company will build Tesco and then burn it to the ground and you will still get your money back over 10 years and retain your holding. You are not paying a bean for the pipeline of drugs that are effectively coming for free.

“It is worse than that because analysts are assuming you will spend $50bn in 10 years on the pipeline and get nothing back. I have never seen valuations like this. These companies have spent a decade going nowhere with their prices largely unchanged.”

GlaxoSmithKline is a perfect example of the fall from grace seen by pharma stocks, with its share price falling 39 per cent in the last 10 years from 1,914p per share on March 2, 2001 to 1,166p per share on March 3, 2011. AstraZeneca’s has fallen 7.67 per cent over the same period.

PSigma income manager Bill Mott also believes pharma stock is attractively priced on a cashflow basis. It is currently his largest sector overweight, representing 14.3 per cent of his £452m fund. He also holds some of the sector heavyweights, such as AstraZeneca, GlaxoSmithKline, Roche and Novatis.

He says: “There is a significant upside but we are not going to be as aggressive as Neil, simply because we feel there are other areas of the market that are also attractive for an income fund, such as tobacco, telecoms and food retail. We do not want to take such an aggressive bet but I do believe pharma is the most attractive sector.”

BlackRock UK fund manager Mark Lyttleton said if he was investing 100 per cent of his fund in defensive he would be more heavily into tobacco than pharma.

But he says: “I feel a lot more comfortable with the story in tobacco as it has pricing power and a stable business and there is less patent and litigation risk. There are also less tax concerns.

“The cashflow characteristics of pharma are quite compelling but what have you got to look forward to? Glaxo has a consumer business that is interesting, Astra does not, so what will it have in five years? Astra’s price to earnings is seven and dividend yield is five so it looks cheap. Its p/e in four to five years time is going to be nine or 10, as it has patent cliffs for all of its drugs. Unless it has high hopes for one of its new drugs, I cannot see the attraction and I would rather own tobacco.”

Liontrust UK fund manager Julian Fosh says: “The simple object of a company is to earn a higher return on its capital than it pays and Glaxo has done that consistently in the past 10 years. The trouble is that 10 years ago it was priced at much higher levels than have been produced. In terms of valuations, the pendulum has swung too far the other way to pessimism.”

“The patent cliff expiry is something that has been common to all pharma stocks. What has been interesting in the past 10 years is that less blockbuster drugs have been discovered. It is a bit like oil exploration – is that structural or is there a good chance of a major success or discovery around the corner?”

OPM Fund Management chief investment officer Tony Yousefian is currently steering clear of pharma but says all it will take is for one blockbuster drug to be produced for that attitude to change and the sector to take off.

He says: “If you look at the huge research and development costs made by these companies, it is no surprise that pharma companies are trading at these prices as nothing has really been produced in the past 10 years. However, that spend means something has to change and if one comes out it will lead to reratings of stocks in the sector.”

Hargreaves Lansdown investment manager Ben Yearsley recently bought into GlaxoSmith-Kline as he feels valuations are now at attractive levels.

He says: “There is always pressure on these pharma companies as drugs come off patent, having an impact on their earnings. It is an unloved sector and the pressure is probably being reflected in the prices. A lot depends on how much confidence you have in the pipeline of drugs these companies have.”


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