Pharma stocks outperform broader indices, may see re-rating as defensive play

The relative earnings visibility in the pharma sector could lead to a re-rating and the Covid pandemic could drive more upside to earnings of pharma companies.

According to research by JM Financial, post-Covid market movements have led to renewed interest and focus on pharma stocks.

"Investor apathy and under ownership have contributed to the sharp outperformance of the sector (Nifty Pharma +16 per cent YTD vs Nifty 50 -per cent YTD). However, for the current rally to be real and the stocks to sustain recent gains, earnings have to turn supportive for the sector. With the steep valuation discount that the sector was trading at relative to its long-term history being bridged, the easy money has been made," it said.

According to research by JP Morgan, the reversal in the multi-year underperformance was expected with the relative preference for companies with defensive earnings in the near term.

However, the pace of outperformance in Indian pharma in the last month was much faster than anticipated with stocks re-rating 45 per cent from lows in March 2020.

"We believe Covid-19 will drive more short-term upside to earnings from upstocking in key markets and increased demand for certain drug categories," it said.

The report adds that the defensive at play makes it the best month for the sector. The Indian pharma sector has been one of the best performing sectors in the recent market sell-off with relatively better earnings visibility in the near term and the inelastic nature of prescription drugs.

While there are risks from the lockdown on the supply chain, these have improved over the last 40 days with companies being able to make supplies (at a slower than normal pace).

Besides this, the defensive bias in the current uncertain environment has also supported the sharp rally in the sector in the last month. BSE Healthcare index had one of the best months (up by 26 per cent in April-2020 versus a 15 per cent up move for NIFTY), reversing its five-year underperformance.

"While we had expected the sector to outperform the market in the near term, the pace in valuation re-rating has been significantly faster than expected.

"We have seen sector EV/EBITDA valuation re-rate 45 per cent from 8x in mid-March," JP Morgan said.

Besides macro issues, there are some similarities in the recent rally in Indian pharma to the global financial crisis (GFC) period.

According to JP Morgan, "Like CY09, we saw the sector bottom out at 8x EV/EBITDA in late March with better earnings visibility and improved 'perception' of the USFDA risk driving the sharp rally."

It, however, says that a post GFC-like re-rating (to 16x vs 12x currently) seems stretched at this point because opportunities due to Covid-19 for Indian pharma (supply chain disruption, higher demand for certain drugs) cannot be extrapolated for an extended period.

In addition, medium-term concerns on the sector have not changed with most large companies, having outstanding FDA issues and incremental returns depending on limited competition launches and de-globalisation of the pharma supply chain requiring shift of production closer to end-market (rather than India/China) is another risk with the decision being more political rather than strategic.

Also, the institutional holding in the sector remains higher than CY09 despite the underperformance over last few years, it said.