(The author is a Reuters contributor. The opinions expressedare his own.)
By Conrad de Aenlle
June 10, (Reuters) - Drugmakers have become fond of oneanother.
The value of mergers in the industry was 20.9 percent higherin the first quarter than the fourth, reaching $44.9 billion,according to a PricewaterhouseCoopers report that predictscontinued robust activity.
The wheeling and dealing has helped lure investors, judgingby the double-digit percentage gains this year in many drugstocks, but it has stirred caution in fund managers with heavyexposure to the industry. With high stock prices and sometakeover bids viewed as less prudent than others, don't getsidetracked by the prospect of further mergers, money managerssay. Instead, they continue to focus on the basics: valuations,growth prospects and income.
A takeover bid that caused much consternation didn't even gothrough after AstraZeneca PLC said "no thanks" to PfizerInc. in April. The episode caused Eric Sappenfield,co-manager of the John Hancock Global Shareholder Yield Fund, to turn cautious on Pfizer, although he still ownssome.
"The bid for AstraZeneca was a 180-degree turn," saysSappenfield, whose fund is a top performer over three and fiveyears among world equity funds, according to Lipper, a unit ofThomson Reuters. "You have to trust management. The jury is outon what management is trying to do at Pfizer. The bid caughtpeople by surprise."
Pfizer is the largest holding in T. Rowe Price InstitutionalGlobal Value Equity Fund, which ranks in the topquintile in returns over the last year among world equity funds,according to Lipper.
"They're very well managed, they're great at generating cashfrom their existing franchise, and they're skilled at deals,"despite the failed attempt to woo AstraZeneca, says the fund'smanager Sebastien Mallet. He likes Pfizer's valuation of 13times estimated 2014 earnings and 3.5 percent dividend yield.
Three of the other top 10 holdings in the T. Rowe Price fundare large drugmakers, too. Overall, healthcare represents 16percent of the portfolio. (The fund has a total expense ratio of0.75 percent.)
"After strong growth in the 1990s, the drug industry "becamecomplacent, with unfocused (research & development) and verylittle to show in their pipelines," Mallet recalls. "The stockswere cheap and controversial, so I bought a lot of them." Inrecent years, he contends, drug companies have become moreefficient businesses, and their research efforts are improving.
One of his holdings, Novartis AG of Switzerland,swapped some of its assets in April for others belonging toGlaxoSmithKline PLC. Mallet expects the move, sort of amerger-lite, to allow the companies to play to their strengths -cancer treatments in Novartis's case.
A big draw of another holding, Teva PharmaceuticalIndustries Ltd., is its cheap valuation of 11 timesestimated 2014 earnings. Concerns about the imminent expirationof patents on its leading drug, Copaxone, a multiple sclerosistreatment, are "overblown" because the Israeli company isdeveloping easier, less expensive, less painful methods ofadministering Copaxone that he expects to limit the appeal ofgeneric versions.
Mallet describes another portfolio constituent, Johnson &Johnson, as "a sleepy company with fantastic assets thatbecame more focused and started to have a better pipeline on thepharma side." At about 16 times estimated 2014 earnings, itsvaluation is in line with the broad market, but "it's a veryhigh-quality company, solid as a rock," he says.
Sappenfield is less interested in value than growth, whichhe considers vital to a company's ability to pay and increaseits dividend. He has a modest stake in Johnson & Johnson, whichhe admires for having "an abnormally high growth rate for thekind of battleship company they are."
PREDICTABLE PROFITS
Sappenfield prefers other drug stocks, though, includingNovartis, Glaxo and two others in Europe, Sanofi SA ofFrance and its Swiss counterpart Roche Holding AG. Hefavors them not just for their ability to grow but to do itreliably.
"Pharma companies generate a reasonably predictable streamof profits," Sappenfield says. "You want to see thatconsistency. That's why we're in the big guys. They're marketingmachines with sustainable pipelines."
His fund has about a 9 percent stake in healthcare stocks -less than average - but he rates drug stocks highly whileshunning other segments of the healthcare group, such as medicalequipment providers and hospital operators. The John Hancockfund has a total expense ratio of 1.34 percent, according toLipper.
Sappenfield isn't too worried about paying the right pricefor stocks, but he hates to pay the wrong price. He soldBristol-Myers Squibb Co because it got too expensive, hesays. "Expectations for some of their drugs were so outrageousthat everything had to be perfect for Bristol-Myers to work."
Mallet expresses some valuation concerns of his own.Although his exposure to drugmakers remains high, it has comedown slightly as price-earnings multiples have increased, and heexpects to cut back further if the trend continues. But he stillfinds far more working for them than against them.
"They have refocused their business models and cut costs,"he says. "The stocks are less cheap, but they still have goodcash-flow generation and dividend payments."
(Follow us @ReutersMoney or at http://www.reuters.com/finance/personal-finance; Editing by Lauren Young and Nick Zieminski)
Astrazeneca (AZN)
Glaxosmithkline (GSK)
