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Getting the Prescription Right is the problem

I like to use two approaches for valuation;

1. The Balance Sheet as the anchor; and
2. The P&L Account as the anchor.
It is a very simplistic approach. The handicap is that I miss out on
companies with no background or with a small track record in terms
of age of business.
The Balance Sheet approach is useful when it comes to looking at
companies that are predominantly in commodity businesses or in
spaces not driven by consumer spending. A simple assumption is
that entry barriers are few and businesses are prone to cycles. Here
I like to use the replacement cost as a Fair Value. This replacement
cost may or may not coincide with the book value, because a
business has other assets and liabilities beyond the core asset
necessary to produce the commodity. These kind of businesses are
characterised by moderate ROCE over a ten to fifteen year period,
with wild swings.
The P&L approach is applicable for those businesses that are asset
light and are dependent on consumer spending. These are
companies that have strong brands, high ROEs and no debt. You will
find them in the space of consumer products and pharmaceuticals.
Of these two, FMCG has more linear predictability. Pharmaceuticals
are a complex group. Let me try and explain why the forecasting of
a pharmaceutical company numbers or arriving at an estimated fair
value for its shares are difficult.
Firstly, there are two distinct types. One is the pharma company that
makes dull products like bulk drugs or is in to Contract Research
Manufacture (CRAMs). These are typically low investment and low
entry barrier businesses and do not challenge us much. They are in
a sense a kind of chemical company.
There is a third set- engaged in BioTechnology, which is also an area
of intense specialisation and high level of unpredicability.
On the other hand, we have companies that invest in R&D, have
best selling products in their portfolio and have a pipeline of
discoveries that are in queue for further action. This gives a huge
unpredictability to a part of their cash flows. Similarly, they would
have products where they own the patent and some where they do
not. A new drug patent gets exploited for about ten years. In India,
this period could be shorter.
Out of 10,000 new products which get in to the R&D platform, not
more than 100 get to the stage of trials on humans and not more
than ten become best sellers later. The R&D cycle is long and there

are no guarantees. Each pharma company may be working on some

drug which has a potential to be a financial winner. A handful of
global companies disclose fully what they are working on and a vast
majority just beat around the bush, trying to be as vague as
possible. Globally, most companies spend between ten and twenty
percent of their sales as R&D!! In India, it is nowhere near this
number. International pharma companies derive nearly 70% of their
sales from patented products and thus when a product goes of
patent, there is a severe drop in sales and profits. This forces them
to spend heavily on R&D in the hope of keeping the pipeline going.
In addition to all this, India also
who thinks that controlling drug
far, that regulator has been a lot
They have not really ruined the
create noises now and then.

has an activist socialist regulator

prices is easy and necessary. So
of empty noise and nothing more.
fortunes of any company, but do

Still, analysts try and forecast the future for the pharma companies!
Since earnings from new products tend to be lumpy and
unpredictable, a degree of estimation is needed. The preferred
method of valuation is the Discounted Cash Flow or DCF. The
future cash flows are estimated and brought to a present value,
assuming a rate of discount. So, in a sense there is a high level of
estimation, forecasting etc. Hence we find that most pharma
company stocks always seem expensive to us.
What I like to do is to be very careful when it comes to Indian
companies. There are some companies where there are
management concerns and I will stay far away from them. A
basically dishonest promoter cannot remain honest for too long. At
some point, he will bite you. Once this screening is done, I like to
look at the ROE. Then the spread of domestic vs global business. I
prefer a company with more domestic business, since the risks of
litigation, pricing, IP etc are lower in India. You have to really know
the industry to take a call on a player who has businesses in this
industry across the globe. I have none and so my choices are
The stock that you pick could be an Indian or a MNC. MNCs typically
make money by selling their globally patented drugs and OTC drugs
at good margins in India. They do not spend much on R&D from the
Indian Balance sheet. I find the MNC pharma companies relatively
safer because they seem easier to understand.
I keep away from Indian companies that go on a spree of acquisition
partly because I do not understand the industry enough and partly
because I suspect most acquisitions.

Pharma companies with domestic market as the main driver of

earnings are what I limit my exposure to. Not because they are the
best of the lot, but because of my limitations. Thus, pharma does
not form a significant part of my portfolio. I find that there are too
many approximations in the price estimation. It is like buying a
story. The one important thing I look for in pharma companies is to
make sure that the company is absolutely debt free, pays a good
dividend and is growing at a rate greater than the GDP. The other
thing is that they should have a wide range of products. I know this
is not easy, but trusting a company with a single product is a big
Government policies and respect for IP are other issues which can
throw a spanner in the works for pharma companies. So far, the
lobbying skills of the industry seem to be good enough to keep the
government away from doing any serious damage in their zealous
pursuit of afordable healthcare for all.
Most of the times, the pharma stocks trade at a premium to other
sectors. The risk reward is not very good either, at the valuation
highs. So, for me to buy pharma company stocks (even those that I
shortlist) means that I have to plunge in without any margin of
safety. Or else, I have to back the aggression of a promoter who is
talking up a good story.
I would like to say that we should buy pharma company stocks when
the valation comes to a level where it becomes a bargain. The key is
to seek established companies that have a good ROE/ROCE, no to
low debt and that which derive a large part of their turnover from
the domestic markets. If I take a snapshot of pharma companies
that have a turnover of more than Rs.500 crores, I see that the P/E
ratios are scattered between thirty and sixty! In a sense, these are
like the FMCG companies, with a far greater degree of uncertainty.
So, happy hunting for those who like to own this sector in their
portfolio. Maybe it is a good option to buy a sectoral pharma fund
(run the risk of manager bias) or a pharma ETF. The sector sure
does deliver above average returns over a long term.
R Balakrishnan
October 24, 2015