How to invest in Pharma Stocks ?

I read about something like pharma stocks are better picks in current situation because they are defensive and cannot hit by recession.

This may be correct but I am not an expert of pharma industry and the industry has some of its internal problem.In current situation most of the well established pharma companies are trading in the PE of range 30-60 like FMCG companies but with a far greater DEGREE OF UNCERTAINTY.

There are 2 approach of anchoring the valuation:

1. Balance sheet Approach
2. P&L approach

Balance Sheet Approach :

This is helpful for companies driven by mainly commodities not by consumers. 

 P&L approach

The P&L approach is suitable for Asset light and dependent on consumer spending. These companies generally have strong brand high ROE and no debt. You will find them in FMCG segment and in pharmaceuticals.Pharma is a complex business and difficult to give a fair value for its shares .

Why is it difficult to analyze a pharmacy company?

Reason 1 :

A Pharma company that makes “dull” products like bulk drugs or into contract research manufacture (CRAMs).The first is a chemical business and and the second is low tech service business. These are typically low cost and low entry barrier business and do not challenge us much. There is a third set which is engaged in biotechnology and which is specialized and highly unpredictable business.

   The companies who invest in R&D have best selling medicine and have few in pipe line always. This gives a huge unpredictability to a part of their business. A new drug generally dominate a market for 10 years and in the case of india it is less than that .Out of 10,000 entry into R&D only 100 get chance to get a chance to human trial and 10 becomes best selling. Globally most of the companies spend around 10% of their spending in R&D In India it is nowhere near this number. Globally when a patended product goes out of the patent we generally observe heavy drop in their sales and profitability.

Reason 2 :

Empty regulatory “Ho Halla” in India:

In India we have activist socialistic regulatory coming every now and then . but in fact it never damages any companies future growth so heavily . But we are not sure and very difficult to say it will not make any impact in future.DCF calculation is one of the approach to calculate the future on the base of current valuation which is damn expensive.

  Also need to check management qualities before doing anything. Once we do these screening we need to check ROE, their global and domestic market spreading, litigation, pricing, intellectual property issues and etc.

  Foreign companies generally make money by selling their patented medicine globally by OTC. They do not spend much from their Indian balance sheet in R&D. Hence MNC Pharma companies are bit easier to understand here because they lack R&D part here.

  I would also like to stay away from those pharma companies who acquire many companies .Here reason is very much personal, my knowledge is limited to pharma companies . Also I do not understand their motive behind this buy out where both the company sell same product for same disease in the market and both are well known. Also The other factors I look in a pharma company are :

1. It should be debt free
2. More wide range of product
3. Good dividend payout history
4. Growing more than country’s GDP rate

In the current situation though I had few companies in this basket but they are trading in a high PE (30-60).Hence I need to compromise with margin of safety . In this case I have 2 options:

1. I need to wait till they come in margin of safety bucket
2. I can invest in some pharma sectorial fund (I do not like from my heart) or a pharma ETF. I know over long run return will be average because of their high PE.

So What is the Pharma Stock you are investing into ?

Disclaimer :

My writing has been inspired by Moneylife.in Magazine Pharma post.