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Is there more upside in store for pharma stocks?

Over the past year, the Nifty Pharma Index has gained 23% while the Nifty has declined by 11% 

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Published a month ago on Jul 04, 2020 Read

Tanmaya Desai, fund manager, SBI Healthcare Opportunities Fund
Pre-Covid, the pharma sector was a significant underperformer for reasons well known: regulatory issues, channel consolidation and pricing pressure in the biggest pharma market, the US. While valuations had come down dramatically, the domestic market had started showing signs of recovery even before COVID-19, given the low base of the previous year and half. Further, though the pandemic has hit just about every industry, pharma is better off given it is a necessity and since exports still make up for 70-75% of the sector’s revenue. Besides the tailwind of a weak currency, Indian companies because of its strong chemistry and cost advantage are expected to benefit in the near term. Concerns on the regulatory front, too, seem to be abating. Over the next 12-18 months, we do expect double-digit growth in exports led by stable demand and a weaker rupee. On the domestic front, the industry witnessed a lot of pre-buying in March to mid-April. That along with some disruption in manufacturing and logistics would lead to some softness in the near term. However, we do expect growth to pick up from Q2FY21.

Rusmik Oza, head-fundamental research, Kotak Securities
Broadly, I am negative on the sector. The BSE Healthcare Index peaked in the 2014-2016 phase, which was the best period for pharma where companies were making a lot of money through exports. But now FDA regulations have become stricter, while consolidation among distributors in the US has resulted in shrinking margins. Also during 2014-2016, many large players were operating at 25-30% return on equity (RoE) and, hence, were trading at 25-30x forward PE — that was the valuation benchmark then. Now, with the change in the margin profiles and increasing competition, RoEs of these companies have come down to 12-13%. Most stocks in this rally have ended up trading at estimated 26x for FY21 and 22x for FY22. Though growth is expected to pick up, given their lower RoE profiles, these stocks cannot trade at stretched valuations. The general sense among investors was that COVID-19 will spur demand for medicines, but during the lockdown demand took a hit in the domestic market as well. Because of lockdown, the chances of people contracting infections, accidents have gone down and even surgeries have got postponed. Only regular critical disorders such as diabetes would see steady sales. Hence, I believe the coming Q1 results will determine which way the stocks are headed.