Do Pharma Funds Make Sense Now?

With the pandemic now being on the wane driven by the intensity of the vaccination drive,will the sector once again fade into oblivion? To answer this question, the article takes you back a little into history and places the current performance in a different perspective

Over the last 15 months the entire equity market has been performing exceptionally well. Barring the FMCG index all the other equity indices have been up by more than 50 per cent in the given period. Among this, the performance of the pharmaceutical sector has been the theme of the last year. In the first six months after the deep cut in the equity market in March 2020, there was a strong rush among investors to own pharmaceutical stocks, which pushed up their prices. Between March 23, 2020 and September 2020, the Nifty Healthcare index was up by almost 73 per cent compared to Nifty 500, which was up by 49 per cent in the same period. Such a move in pharmaceutical stocks attracted lot of investors towards the funds dedicated to this sector. 

Pharmaceutical-dedicated funds have attracted huge inflows in last six quarters. The cumulative asset under management (AUM) of these funds has increased from Rs 6,000 crore at the end of December 2019 to Rs14,000 crore at the end of June 2021, increasing by almost two and a half times. Such a rise in AUM is contributed by both rise in the mark to market gains and net inflows.

Nevertheless, the momentum has slowed down after that for Nifty Healthcare index. In the first six months of 2021, Nifty Healthcare has been up by 15 per cent compared to 18 per cent growth seen in Nifty 500. Such underperformance was also observed in the change in weightage of pharmaceutical companies in the overall equity holdings of mutual funds schemes. Analysing the overall weight of healthcare companies in equity-dedicated mutual funds, we see that after touching a high in the month of September 2020, their weightage has declined.

For the months of March and April this year the weightage increased but once again declined in the month of May. At the end of May, the weight of pharmaceutical stocks stands at 7.4 per cent, which is much higher than 5.24 per cent weight that the pharmaceutical companies command in the Nifty 500 index. The chart below shows the movement of weightage of pharmaceutical companies in domestic equity mutual funds, which clearly shows that they peaked in the month of September 2020.

Does it mean that the spurt of performance in the pharmaceutical sector was momentary and primarily driven by the pandemic? With the pandemic now being on the wane driven by the intensity of the vaccination drive, will the sector once again fade into oblivion? To answer this question we will go back a little into history and place the current performance in a different perspective.

Long Lull Before Spurt
The current rally in the pharmaceutical sector should be looked against the background of its huge underperformance which the sector had posted before the current rally started. Nifty Healthcare touched its peak on April 2015 and after that it fell by 45 per cent in the next five years. In fact, Nifty Healthcare generated negative returns for four consecutive years between 2016 and 2019. It was only in 2020 when the healthcare index generated positive returns after 2015.

The table above indicate Nifty Healthcare’s worst five draw- downs from 2005. The last one is clearly the longest and the deepest one. Hence, the current surge is not just related to the pandemic. One needs to understand that since the sector was languishing for so long, the time was ripe now for it to come out of deep slumber. The pandemic simply accelerated the process. The graph above (Weight of Healthcare Companies in Equity MF Schemes) clearly shows that mutual funds started raising their weightage in pharmaceutical companies from December 2019, almost three months before the world took notice of the corona virus.

Structural Change
One of the reasons for underperformance of the pharmaceutical funds from FY16 to FY20 was the huge capex taken by the big pharmaceutical companies during this period. These companies spent on expanding their capacity and research and development base which was more than 2.5 times cumulatively from FY16 to FY20 as compared to FY11 to FY15. Higher capex and lower cash flows led to fall in return ratios and de-rating of the sector and pharmaceutical companies fell out of investors’ favour. Besides, there were other issues that plagued the sector during that time, primary being the price erosion of the product they faced in their biggest market, the US.

There was also increased scrutiny of the Indian pharmaceutical companies by the US Food and Drug Administration (FDA) which delayed the launch of various products. India accounted for nearly one-third of the total foreign inspections by FDA between October 2018 and June 2019.

Nevertheless, the situation is changing now. The pace with which prices were dropping has been arrested and there is lower pricing pressure in the American market. It is, however, achieving some sanity now. While the regulatory environment is expected to remain stringent, well-equipped companies will be able to take the advantage of a better pricing outlook emanating from supply shortages.

According to a report by India Ratings, at the end of December 2020, Indian companies were able to bag approvals in a large number due to significant manufacturing facility clearances, generic drug user fee amendments and a strong filing momentum aided by record investments in research and development. Indian pharmaceutical companies have garnered 45 per cent of all new abbreviated new drug application (ANDA) approvals over the past nine months, the report informs. Besides, recent government measures such as the performance linked incentive (PLI) scheme for the pharmaceutical industry has been extended from FY21 to FY29. With this boost, there shall be an investment of  Rs15,000 crore in the sector.

What has also changed for good in the last few years is the structure of the entire sector. Earlier the sector was dominated by a few large companies drawing most of their revenue and profit from the US market. Nevertheless, now the healthcare domain has multiple sub-segments, each of which has unique growth levers which not necessarily depend on the US or other developed markets to grow. The healthcare sector is a very diverse now. There are companies dominant in the domestic formulations business, some have major presence in export formulations and then there are companies listed in the diagnostic and hospital space that also form part of the healthcare sector.

Today, there are more companies in the listed universe. The sector now includes hospitals as well as equipment and pathology companies. Funds can also invest in international companies. There are reports of medical retail stores and pharmacies entering the listed domain. Today, the healthcare sector is more mature and diverse. This has resulted in the sector becoming less cyclical and more stable. So now the pharmaceutical sector funds have a wide category of companies within healthcare to invest in.

Therefore, the current surge in the pharmaceutical sector is not transitory in nature and we may see better and stable performance from the sector going ahead. From 2012 to 2015 when the sector was in a bullish phase it outperformed the equity market represented by Nifty 500 by almost 100 per cent in a span of 3.5 years. The chart below shows the performance of Nifty 500 and Nifty Healthcare from January 2012 to April 2015.

The weight of pharmaceutical stocks stands at 7.4 per cent in equity MF schemes, compared to 5.24 per cent weight that it commands in the Nifty 500 index.

Better Days Ahead
The financial results of the fourth quarter of FY21 for pharmaceutical companies were a mixed bag with a not-so- encouraging performance from the US business. Margins were strong but a large portion is factored in into the market prices. For the domestic formulation companies, cost-saving measures were the biggest driver in their Q4FY21 performance. Going forward, we believe moderate recovery is likely to continue in domestic pharmaceutical revenues. Revenue in key markets, including the US and Europe, will also benefit from a healthy pipeline of generic drugs and further progress in launches of specialty drugs by larger companies.

For FY22, Indian pharmaceutical companies are likely to post robust performance. This will be on the back of normalisation in sales of the categories affected by the pandemic in the previous year. A report by Fitch Ratings says that ‘sales of drugs used to treat acute medical conditions and elective procedures to continue to recover in FY22. Sales in these categories fell in FY21 as travel restrictions reduced doctor visits and hospitals prioritised corona virus treatment over elective procedures. Sales of some of these products are still 10 per cent below pre-pandemic levels, although they started to recover with the easing of curbs’.

Therefore, it doesn’t mean that the end of the pandemic will mean the end of the road for the healthcare sector. There are multiple tailwinds that are acting in favour of the sector and hence we believe there is still some juice left in it. Given the rally we have seen in the last 15 months, most of the pharmaceutical stocks are not attractively priced and therefore it make sense to invest in them through mutual funds and that too through the SIP route.

Best Pharmaceutical Funds
There are only nine domestic mutual funds dedicated to the healthcare sector and of these only four funds have completed five years while the rest are younger. The following table gives a glimpse of the current domestic pharmaceutical funds.

The chart below shows the performance of the funds over the last 18 months. The best performing fund is Mirae Asset Healthcare Fund with a gain of 214 per cent followed by DSP Healthcare Fund with growth of 210 per cent

There are only a handful of pharmaceutical funds that have completed 10 years. Most of the funds were launched in 2018 and 2019 and hence there is no performance record of such funds between 2015 and 2019 when the sector was going through huge underperformance. Therefore, we will limit our study to only such funds that have at least completed five years.

We have used four factors to evaluate each fund. These factors are the capture ratio, max draw-down, beta and geometric information ratio. We ranked the funds based on these parameters and after giving proper weightage to these ranks we arrived at the best fund. For aggressive investors, SBI Healthcare Opportunities Fund makes sense as it has higher beta. For moderate investors, Nippon India Pharmaceutical Fund is a better choice as it falls less when the benchmark falls.

The Timing
There is no doubt that the longer term outlook for the sector looks attractive. Nevertheless, the near term upside may have been already captured. Hence, do not expect last year returns to repeat this year also. Pharmaceutical mutual funds are sectoral which invest in companies primarily engaged in the health sector. They need to invest 80 per cent of their corpus in pharmaceutical companies as per the SEBI mandate. Therefore, despite the diverse sets of companies listed from this sector their fortune is very much tied with the healthcare sector.

As such, these funds are suitable only for aggressive investors who have high risk tolerance with investment horizon of more than five years. Moreover, if you are not able to identify the cycle of underperformance or outperformance, it is always better to follow a systematic investment plan or SIP.

The actual allocation to this sector will depend on your overall equity portfolio. If you are holding funds that already have higher weightage for pharmaceutical companies than you can even skip investing in pharmaceutical funds. In no circum- stances your overall exposure should exceed 10 per cent of your portfolio and your choice should be related to your risk appetite.