While the market is bleeding, pharma sector has withstood the lock-down. Can it be a good bet for investors?

Rahul Agarwal, Director, Wealth Discovery, explains how the once beaten-down sector, has recently witnessed sharp uptick with majority of stocks gaining 10 to 40 per cent within a month, and why investors should look into this space

The ongoing COVID-19 pandemic has wreaked havoc across world economies and consequently the global stock markets. India equity markets have also followed suit with major indices correcting to the tune of 30 per cent from their highs. In the Indian context, large scale mayhem has been witnessed across sectors. However, in this gloom and doom, pharmaceuticals has been the outlier, and for good reasons. The once beaten-down sector, has recently witnessed sharp uptick with majority of stocks gaining 10 to 40 per cent within a month, some marquee names in this space are at or closer to their 52 week highs. The following table shows the recent performance of select pharma stocks listed on the Indian bourses. On a broader level, the performance of the pharma stocks measured by the BSE healthcare index has outperformed the benchmark indices by a huge margin.

The change in the investor sentiment ahead of any change in fundamentals or performance numbers may be surprising, but is justifiable — pharma stocks were underperformers for a long time, and therefore suitable candidates for valuation re-rating.  The ongoing global pandemic has offered a new lease of life for some speciality pharma companies engaged in the manufacturing of hydroxychloroquine, while others have benefitted from the rush to safety that the pharma sector offers in troubled times. Indian pharma has been relatively resilient to the COVID-19 disruptions on the supply side, and is also poised to gain from the favourable currency tailwinds and stable outlook for India and the US business.

Globally, Indian pharma companies are considered leaders in the generic pharmaceuticals market with significant exposure to developed economies both in North America and Europe and have a good reputation when it comes to safety and quality. In recent years, however, these companies have witnessed intense competition from China who has been able to leverage its scale and cost competitiveness, especially in Active Pharmaceutical Ingredient (API’s) manufacturing. The questionable conduct of China in its role towards the spread of COVID-19 pandemic, however, has made economies, especially the developed ones realise their vulnerability due to too much dependence on China for their API needs. Although, India largely depends on China for its API needs, the current crisis has opened a window of opportunity for the Indian drug manufacturers to diversify their supply chains and to rely more on domestic suppliers which is a positive development in the longer term for the entire sector.

From an investment perspective, after the initial exuberance in which all pharma stocks have rallied in the short term, going ahead, the rally could sustain for companies with good fundamentals and fair valuations. Those with business uncertainties, regulatory clampdowns, governance issues and litigation risk may fall out of favour, despite the positive sentiment. Apart from this, companies with stressed cash position or smaller companies who are unable to meet the compliance costs and R&D budgets will find it difficult to survive in the longer term.  Therefore, investors should focus on those players who have the ability to invest and have very strong cash flows because of their dominant position in the domestic market. Few stocks which are in an advantageous position in the current situation are Dr Reddy’s, Cipla, Abbott India, Laurus Labs and Ipca, and investors may look to gain an entry into these stocks with a longer-term outlook. Valuations should be another criterion that investors should analyse carefully before investing. For example, both Dr Reddy and Sun Pharma are contenders for investment but from a valuation perspective, Sun Pharma offers a better risk reward than Dr Reddy’s as the latter is already trading at a stretched valuation.

To summarise, Indian pharma companies had been an underperformer over the last few years and finally the tide has turned for them, albeit in unfortunate circumstances. The global pandemic has thrown open a lot of opportunities to Indian pharma companies, just recently several of them received US FDA nod for their manufacturing facilities. India has won a lot of good will in its effort to supply world’s hydroxychloroquine need, which, in turn has helped the perception of Indian generic drug manufacturers. India pharma companies are well-positioned to leverage this opportunity. Therefore, investors should look into this space, although with discretion and a longer-term outlook.