Economic & Market Review - December 2014

by Gavin Graham, Chief Strategy Officer December 29, 2014
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
The outbreak of the deadly Ebola disease in West Africa this year has focused investors’ attention on healthcare stocks, and several drugs and medical equipment companies have benefited from being regarded as providing solutions to the issues raised by this appalling virus. The reissue of a new version of “Do They Know It’s Christmas?” by the reformed group of pop stars calling themselves Bandaid, 30 years after the original single was issued to fight famine in Ethiopia, is one of many worthwhile efforts to raise funds to fight the disease.

As with the outbreak of avian influenza (“bird flu”) a decade ago, which led to a collapse of Toronto’s tourist traffic and a pop concert headlined by the Rolling Stones to raise funds, it sometimes seems that only rapidly spreading infectious epidemic diseases can arouse sufficient interest and energy amongst governments and their citizens to do something to counteract them.

Yet the ravages of long-term chronic diseases such as cancer, multiple sclerosis, hypertension, high chloresterol, diabetes, macular degeneration (blindness) and asthma are much more widely spread, affect many more patients, and are the biggest cost to national healthcare systems. While capable of dealing effectively with accidents and emergencies and large obvious threats such as bird flu and Ebola, health care systems face much graver and longer term problems in dealing with aging populations with chronic if non-life threatening conditions.

One of the most effective ways of addressing these problems, both in terms of time such as the capacity of medical staff and resources such as hospital beds, as well as cost, is developing and using medicines that keep conditions under control, allowing patients to lead normal and productive lives. While improvements in lifestyle such as diet and exercise are one obvious path to follow, given the human propensity to backslide and “fall off the wagon”, effective drugs provide a more certain remedy.

Such straightforward options as taking aspirin and statins on a regular basis has been shown to greatly improve quality of life and life expectancy, as have beta blockers for hypertension. There will always be some groups for whom these broad categories of drugs are less effective, and one of the most interesting and fastest growing areas of medical research in the last couple of decades has been using the mapping of the human genome system to target drugs for much smaller groups of patients.

However, many of these smaller drug companies are dependent upon one drug, often being sold at high prices to a small group of sufferers, and very vulnerable to generic competition and price reductions by healthcare systems. For the vast majority of investors, including pension funds, owning large well-diversified pharmaceutical companies has been the easiest and most profitable way to gain access to this sector.

However, having been bid up to high valuations after the collapse of the technology bubble at the beginning of the last decade, many of the large pharma stocks have turned out to be very disappointing investments. Either their sales practices fell foul of the Federal Drug Administration (FDA), their drug pipelines were disappointing or, most importantly, their blockbuster drugs succumbed to generic competition much more rapidly than expected, with sales collapsing as much cheaper but just as effective copies became available.

Over the last decade, such drug majors as GlaxoSmithKline (GSK-N), Pfizer (PFE-N) and Eli Lilly (LLY-N) have only returned 1-2% p.a., plus 2% p.a. or so in dividends. Even better performing pharmaceutical companies like Johnson & Johnson (JNJ-N), Novartis (NVS-N) and Astra Zeneca (AZN-N) have risen by only 5-7% p.a., in line with the TSX Composite and S&P500, although investors have received 2-3% a year in dividends as well.

It now appears as if the period of relative under-performance is coming to an end. Firstly, most of the major blockbuster drugs which drove companies’ performance in the last fifteen years such as Lipitor for Pfizer and Advair for Glaxo have come off patent or are due to do so within a year or two, and the bad performance of these stocks has reflected this and also made them appear good value. Pfizer is selling at 13.7 times 2015’s forecast earnings and Glaxo at 15.1 times, both well below the 18 times the S&P500 sells at, while even better performers such as J&J, Novartis and AstraZeneca are selling at 16.5-17.5 times 2015 forecast earnings, with dividend yields ranging from 2.4% for Astra to 5.3% for Glaxo.

While the pharmaceuticals sector is very under-represented in the Canadian market, the US and European stock markets have heavy exposure to this area, both in terms of large pharmaceutical companies such as those mentioned, and also to smaller drugmakers and medical equipment stocks. While this has been an industry that has under-performed the broader market for the last decade, the longer term demographics of aging populations in developed markets and rapidly growing and wealthier populations in emerging markets mean that long term investors can gain exposure to a sector with reasonable revenue growth and a sustainable and growing yield which is selling at a reasonable valuation. Investors should check their pension funds to determine what ownership they have in this area.