Abating pricing pressure in US market good news for pharma funds

While the risk from USFDA strictures remains, aggressive investors may take limited bets with 5-7-year horizon

In contrast to their strong performance in 2020 and 2021, pharmaceutical and healthcare funds experienced a decline in 2022, with returns plummeting by an average of 9.8 per cent. This trend has continued in the current year, with year-to-date return remaining in the negative (-4.9 per cent). In the past three months particularly, pharma funds have been hit hard, experiencing a decline of 7.9 per cent.

Post-Covid-19 blues

A number of factors affected the sector’s earnings in the post-Covid-19 period. “Excess stocking in the supply chain, rise in raw material costs due to China-led shortages, and weak pricing in the US market are the key reasons for the weakness witnessed in the near term,” says Sailesh Raj Bhan, chief investment officer-equity investments, Nippon India Mutual Fund. He adds that some of these trends are bottoming out, and this is likely to be reflected in improved earnings over the next few quarters.

Dharmesh Kakkad, fund manager, ICICI Prudential Asset Management Company (AMC) attributes the sector’s recent underperformance to US Food and Drug Administration’s (US FDA) observations (the US regulator pulled up some of the Indian pharma majors after inspecting their factories) and stretched approval timelines for complex generic products in the US. According to him, the lowering of the drug price ceiling under the Drug Price Control Order (in the domestic market) was also responsible for the sector coming under pressure.

Chirag Dagli, fund manager, DSP Mutual Fund, says that hospital and pathology stocks, which did well during Covid-19 and supported the performance of these funds, have either corrected or have been flat.

Positives on the horizon

Fund managers, however, remain upbeat on the medium to long term prospects of the sector.

Export markets: According to Dagli, the US business is turning around, with third-quarter numbers showing reasonable growth for most players. While the recent growth was partly due to the flu season in the US, the trend is likely to continue. “New product launches are in the pipeline. The trend of double-digit price erosion in the base business is also beginning to normalise to more manageable levels of high single digit,” adds Dagli.

The existing players are rationalising the pricing of their US generic portfolios. Says Kakkad: “A few players are also exiting the market, given that segment profitability has deteriorated considerably.” These developments could result in improved pricing power for Indian companies.

According to Bhan, exports to non-US markets like emerging markets and Africa are also improving.

Domestic market: Dagli points out that in the domestic formulations market, starting from April 2023, products under the National List of Essential Medicines (NLEM) will be allowed to take wholesale price index (WPI)-linked price hikes. “This will affect about 20-25 per cent of the domestic market,” he says.

The share of domestic branded business in overall profit share has been increasing, according to Bhan. He expects this trend to continue with the population of those aged above 50 likely to rise sharply.

Hospitals have experienced normalisation of their business. Dagli believes occupancies will increase in the first and second quarters of the next financial year. Bhan is of the view that the increased adoption of health insurance during Covid-19 will be a positive for the hospital sector over the medium term.

According to Kakkad, companies have indicated that raw material prices have begun to soften.

Take limited exposure

The sector is reasonably valued after its relative underperformance vis-à-vis the broader market over the past 12-18 months. “It offers the prospect of reasonable growth along with improved earnings possibilities,” says Bhan.

Sector funds, however, are less diversified than diversified-equity funds, and hence carry higher risk. Viral Bhatt, founder, Money Mantra warns that regulatory changes have the potential to impact their returns.

Investors who have knowledge of this sector, or have the ability to do research on its opportunities and threats, may enter these funds.

“Enter with a horizon of five-seven years or more. Exposure shouldn’t exceed 10 per cent of your total equity investment,” says Bhatt.

Investing via the systematic investment plan (SIP) route will help you cope with volatility better.