Since there are only a handful of healthy pharma stocks, it's best to avoid pharma funds and buy individual stocks instead
You'll often hear fund managers advocate the virtues of active management and diversification and mutual funds as the ideal investment avenue as it offers both.They will tell you that active management and diversification will help you outperform the market. And to their credit, more often than not, mutual funds tend to outperform the market.
However, sector funds are different. While they offer the benefits of active management, there is limited diversification. Since you are investing in one particular sector, your investment options are limited and when the sector is caught in a downturn, the holding period can be quite painful and long.
For instance, not too long ago, most investors burnt their fingers with tech funds. Tech funds had a phenomenal run till the tech meltdown happened and have never been able to fully recoup their losses.
Pharma funds, after a good run in the past two years, are not in the best of health currently. However, you can be sure that the you are unlikely to see the volatility that came with tech funds given the defensive nature of the pharmaceutical industry.
However, pharma funds have underperformed in the past one year. In the past year, pharma funds on an average generated a return of 6.98 per cent nearly three per cent lower than the benchmark, the BSE Healthcare Index.
Here, the active management clearly didn't seem to help the fund's performance. This underperformance is more conspicuous when you compare the performance of individual stocks such as Ranbaxy and Glaxo SmithKline have done much better generating impressive returns of 43 and 62 per cent, respectively.
This is not unusual in a developing market like India where individual companies showing a lot of promise are traded at a substantial premium to the industry average. This because the investible universe of stocks are restricted to a couple of hundred stocks and a potentially promising growth story can send the stock price to the moon.
In the pharmaceutical industry, the difference in valuations are more distinct for various reasons. A company with basic research skills and a presence in the international markets gets a huge premium to the industry average.
For instance, Ranbaxy which can boast of both decent research skills and a growing international presence gets a price multiple of 27 times, whereas Morepen ,whichis still to get a toehold in the generics market and research expertise yet to be established, gets a discounting of 5 times.
In the past year while Ranbaxy gained 43 per cent, Morepen lost over 50 per cent. So take a pharma fund which has both stocks, Morepen's performance can be a drag on the overall fund performance. Understandably, even if the weights given to both stocks are different, the overall return still gets affected. So the case to invest in individual stocks rather than a pharma fund which offers a portfolio of stocks becomes more compelling.
Sector funds do come with their restrictions. In a sector fund, you cannot invest more than 15 per cent in an individual company. So, in a bid to invest stay fully invested, funds have to take exposure in second-rung companies.
The risk associated with second rung stocks are very high and in a downturn or when stocks markets are on a decline, these companies take a bigger hit. So, the risk reward ratio is not always in favour of these companies.
Take for instance the case of Magnum Pharma, investing in smaller companies such as Shasun chemicals, JB chemicals and Glenmark cost the fund dearly. In the past three months, Shasun chemicals lost nearly 35 per cent in value, JB chemicals declined by 25 per cent and Glenmark lost nearly 40 per cent. On the other hand top rung companies gained marginally or their stock prices remained more or less intact.
For instance, Ranbaxy gained four per cent, Sun pharma remained steady gaining a marginal 1.50 per cent and GlaxoSmithKline held ground stay at Rs 365 levels. However the weak performance of the smaller companies took a toll on the magnum
