Pharma emerges the star of the market in April 2020

What exactly is the story behind this pharma rally?

May 06, 2020 10:05 IST India Infoline News Service

The markets were sharply up in the month of April. Whether it was short covering or fresh buying is something that will be confirmed in the coming weeks. Nifty returns were extremely attractive at 29.56%. Most of the sectors gained around that much, but two sectors actually stood out as shown below.

Data Source: NSE and BSE

The two sectors that stand out are pharmaceuticals and oil & gas. Of course, the oil & gas story was largely predicated on asset monetization plans of Reliance Industries via the Facebook deal and the proposed rights issue. But, the outlook for the sector continues to be clouded with crude oil prices at around $25/bbl. That leaves us with Pharma, which gained 45% since the lows of March 23rd.  What exactly is the story behind this pharma rally?

Clearly pharma appears to have got a new lease of life in the midst of the Coronavirus pandemic. Interestingly, the 45% returns since 23rd March has been the best (40-day) returns generated by the pharma index over the last 22 years so obviously there is something working for pharma. At a basic level, equity investors flocked to pharma stocks on expectations of these companies benefiting substantially from the development of a vaccine to counter the pandemic. The virtual shortage of low cost generics globally had opened a huge window of opportunity. But there were other compelling reasons too.

Supply side concerns addressed
When the Coronavirus first struck, the big concern was the supply chain disruption. With the Indian pharma industry largely dependent on China for feeding its supply chain, the initial reaction was acutely negative. However, in the last few weeks, the key pharma pivots of Wuhan and Hubei have been returning to normal. As China’s KSMs (key starting material) resume and disruption risks reduce, Indian pharma companies are positioned in a recovery sweet spot to grab opportunities in the COVID-19 environment.

Earnings could see a turnaround in Q4
Most pharma companies will announce results in the month of May. For Q4, the sector is expected to report strong earnings growth on the back of panic buying of medicines and healthcare products. In addition, the global demand for drugs like Hydroxychloroquine (HCQ), Oseltamivir and other anti-virals to fight COVID-19 opens up a huge growth opportunity in Q4. During the March quarter, most of the large and medium sized pharma companies have already seen a spike in orders as panic buying of generics continues at a rapid pace. In addition, the appreciation of the rupee has also helped these pharma companies to report improved export performance.

Pharma sector is betting on lenient regulations
When the structural correction in Indian pharma started in 2015, one reason was the intensifying competition. But the bigger and more potent reason was that the US FDA was getting stringent on Indian pharma’s lax manufacturing and testing standards. That has been the underlying theme of the US FDA over the last four years with the FDA specifically singling out India for harsh treatment in terms of approvals and Form 483 reviews. In the last 4 years, despite reasonable valuation metrics, pharma sector has struggled with earnings growth due to unrelenting FDA concerns. However, things appear to be changing rapidly in the post COVID-19 scenario. Large institutional investors are also expecting that the US FDA will take a lenient stance on inspections going forward. This would sustain at least till the time the shortages of COVID-19 drugs continue.

Pharma may emerge as the big defensive bet

Index Name Beta Value Nifty Correlation Price Earnings Ratio (P/E) Price Book Ratio (P/BV) Dividend Yield (DY)
Nifty Pharma 0.63 0.67 28.81 3.57 0.58
Data Source: NSE
Data Source: NSE
Clearly, valuations may still not be a very strong case for the pharma sector. The P/E of over 28 and dividend yield of just 0.58 will require very strong earnings growth to justify valuations. As of now the more compelling argument appears to be pharma as a defensive bet. With a Beta of 0.67, the index dependency is quite low and hence would be a natural candidate as a defensive bet. The low correlation also indicates that the overall market explains very little of the pharma sector movement and that would make it the perfect defensive candidate. There are two more factors. Firstly, the COVID-19 lag effect is likely to last for some time now and till then the FDA regulations are likely to remain favorable to Indian generics. Secondly, risk-off investing is likely to keep the rupee under pressure and that will again benefit Indian pharma.

In the midst of the warning letters and Form 483 objections, pharma has emerged as a solid defensive bet. At least, that has been the evidence in the last month and half!

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