Drug Stocks: Starved for Capital

Drug Stocks: Starved for Capital

Fears that drug pricing will collapse have pushed many investors away from this sector, yet we see drug spending becoming less, not more, of an issue going forward: given current valuation levels, the potential for stronger returns is very real.

Prevailing Drug Narrative Leaves Room for Improvement

With mundane cyclical risks, such as U.S. dollar strength, and scarier structural risks, such as a real trade war, on the radar, it becomes increasingly important to be alert for situations where the prevailing market narrative has starved fundamentally well-positioned areas of capital.

For us, one such area is U.S. drug stocks: this defensive group has fallen on hard times despite very strong fundamentals for select stocks. Investors may not be taking policy risk from a trade war seriously, but they have fully embraced drug pricing risk. The prevailing narrative is that biotechnology and pharmaceutical stocks are not investible because drug pricing is at risk of collapsing. This narrative has unfortunately been supported by bad behavior from fallen drug-stock market darlings like Valeant, which absolutely abused pricing power. President Trump has also promised imminent drug price declines, spreading the idea with his tweets.

But we see drug spending becoming less, not more, of an issue. Net pricing for branded prescription drugs have risen only 2.4%, 3.2% and 1.9% in the past three years, despite list price increases of 7% to 12% that power the headlines. This limited net pricing has actually kept drug spending as a percentage of U.S. GDP stable since 2010.

Health Care and Drug Spending as a percentage of U.S. GDP

As of December 31, 2016. Source: Center for Medicare and Medicaid Services, St. Louis Fed (FRED).

Despite the reality of stable drug pricing, the drug price narrative has led to a massive derating of drug stocks. Currently depressed valuation levels have been rivaled only by Hillarycare and Obamacare fears, which generated equally powerful drug pricing risk narratives (see chart below). However, drug stocks have delivered strong forward returns from depressed valuation levels before, and we think this will be the case once again, as reducing drug pricing is a very challenging policy goal to actually implement. The complexity and difficulty are evident in the lack of actionable ideas in the recently announced Trump drug pricing proposals. As more benign policy realities give way to decent fundamentals at a massive discount, we think the opportunity in drug stocks will be realized. 

Drug Price Narratives and Stock Pricing

Source: Goldman Sachs Research. Data as of June 18, 2018. Composite includes Pfizer, Johnson & Johnson, Merck, Bristol-Myers Squibb, Eli Lilly, AbbVie, Gilead Sciences, Biogen, Amgen and Celgene.

Top

IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.