Investors should stick to stocks of firms focused on domestic market

Pharma firms can build brands and enjoy higher margins here

While the Sensex is up 22.6 per cent over the past month, the S&P BSE Healthcare Index has clocked a much higher gain of 38.1 per cent over this period. The sector, which has been an underperformer since 2016 (see table), has caught investors’ fancy since the start of the Covid-19 crisis.  

Several factors have contributed to this change in preference. Since pharma and health care are essential services, they are likely to see less disruption than others. “Banking and financial services, automobile, industrial, infrastructure, and information technology are expected to be affected. Pharma and health care, on the other hand, offer valuation comfort and earnings visibility,” says Aditya Khemka, fund manager, DSP Investment Managers.

The rupee has weakened against the US dollar and the euro. “Most large pharma companies have significant exposure to these currencies and will hence, benefit,” says Vrijesh Kasera, fund manager, Mirae Asset Healthcare Fund.

The sector’s fundamentals had begun to improve four-five quarters earlier. Indian pharma companies’ export business is commoditised in nature as they are not allowed to build brands in markets like the US.

“Between 2015 and 2019, the return on equity (RoE) of the export business fell due to high supply in the US market. Since last year, many competitors have exited that market due to very low returns. With supply falling, prices have stabilised and may rise soon, leading to improved RoEs for Indian companies,” says Khemka.

 

 

The domestic market is expected to clock steady growth. “We expect the Indian pharmaceutical market to grow at around 8-9 per cent in 2020-21,” says Bharat Celly, pharma analyst, Equirus Securities.

Moreover, no negative surprises are expected from the US Food and Drug Administration’s (USFDA’s) checks — at least in the near future. “The pace of approvals could rise for drugs that are in short supply in the US,” says Bansi Desai, institutional research analyst, HDFC Securities.

Many countries source active pharmaceutical ingredients (APIs) from China, but may diversify their supplies. “Countries will focus more on security of supply rather than on pricing,” says Kasera. India, a major API producer earlier, could capture that opportunity.

Health care as a whole may also benefit, as the government hikes its budgetary allocation to the sector, and customers opt for regular health check-ups.

Investors should remain mindful of the risks. The first pertains to competition in the export business. If supply rises again, Indian players’ returns could be hit. “Long-term investors should monitor competitive intensity in the US,” says Khemka.

The sector also faces currency risk. Whenever the rupee appreciates against the dollar, export earnings get affected, hitting export-oriented companies. And whenever it weakens, the cost of imported raw materials rises.

Regulatory risks could return. The USFDA could issue warning letters to Indian manufacturers’ plants again in the future. The domestic business also faces the risk of price control. “India could see a new National List of Essential Medicines during the year, which could slow down growth,” says Celly. Valuations are no longer cheap. The BSE Healthcare Index has, on average, over the past 10 years traded at a 40 per cent premium to a front line index like the Nifty. Currently, it is once again at that level, though it is still far from its peak of 130 per cent premium.

Direct investors should stick to companies that derive a larger share of their revenue from the domestic business, where companies can build brands and enjoy higher margins. “Avoid companies with consistent regulatory issues and inferior capital allocation,” says Desai.

Also, avoid companies whose valuations have already turned rich. When selecting a fund, look for one whose portfolio is more skewed towards companies with predominantly domestic businesses.