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Pharma Looking Defensive Again

Jeremy Glaser
Damien Conover, CFA

Jeremy Glaser: For Morningstar I'm Jeremy Glaser. The big pharmaceutical stocks have outperformed the broader market over the last year. I'm here today with Damien Conover,  director of pharmaceutical research, to see if there is still value left in these stocks and if so where it is.

Damien, thanks for joining me.

Damien Conover: Thanks for having me, Jeremy.

Glaser: As a sector we used to think of pharmaceutical stocks as being pretty cheap. Quarter-after-quarter we always looked at them as one of the least highly valued sectors, but that really has turned around recently. What's driven that outperformance from these stocks, and do you see any value there?

Conover: I think that's a really good question, Jeremy. When we look at the strength of the pharmaceutical stocks over the last year, a lot of that has been driven by the pharmaceutical stocks moving into their major patent cliff and adapting to that patent cliff better than what I think investors were anticipating. They are cutting costs, they are getting their pipelines back on track, and they are getting to be much better-positioned than I think most investors had feared would be the case moving into this patent cliff. Going forward we anticipate that these stocks are still undervalued, and as a group we see the pharmaceutical stocks as about 10% undervalued. And some of those drivers that I mentioned, such as cost-cutting and better pipelines, we expect will really move the group higher

Glaser: But certainly economic growth has to be a concern. Certainly, we think of these stocks historically as being somewhat defensive, but during the last downturn they sold off pretty sharply. Would you expect that this sector would hold up better-than-average if we were to enter another sustained global slowdown?

Conover: I think so. I think investors are starting to look to this group again as a defensive space. If we look back at the past recession, this group traded down with the broad market, but I think that also coincided with these firms really at the beginning of the patent cliff. So there were lot of stock-specific reasons for these names to trade down, at the same time the market was pulling back. As we move into potentially another recession, and if we do move into another recession, I think these stocks will hold up better than in the last downturn, and that's largely to do with the fact that the patent cliff is getting behind these names and pipelines are starting to improve.

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Glaser: When we think about some issues in this recession that weren’t there before, like how fiscal problems in Europe could lead to pressures on drug reimbursements--certainly those are pressures that are being felt here in the United States and also elsewhere--are those kinds of trends really going to provide a pretty big headwind for these firms?

Conover: There are going to be some headwinds for this group, particularly in Europe. Europe austerity measures are causing pricing pressure for the pharmaceutical group that they haven't felt in decades. However, that geography is being somewhat offset by strong tailwinds actually in the U.S. where we're actually seeing very strong pricing power and good pricing power in emerging markets. So some of the other geographies are actually helping to offset some of those headwinds that we're seeing in Europe right now.

Glaser: What are some of your favorite stocks in the sector?

Conover: Right now one name that we think has a lot of potential and we see it as undervalued is Pfizer. Pfizer is a firm that actually has done very well with its patent cliff, cutting costs and really getting entrenched in emerging markets, which are two trends that we think will bode quite well for the company. Also its pipeline looks better now than I think it's looked in the past five years, so it's really starting to turn the corner with better pipeline and really starting to bring out new next-generation products.

Glaser: Are there any other names that seem interesting?

Conover: One other name that we would mention is Novartis. Novartis has what we believe to be one of the best pipelines out there, really going after diseases that hit smaller patient populations, but there really aren’t a lot of products out there for these groups. And so the Food and Drug Administration will very quickly approve these products, and you also get very strong pricing power with payor groups for these smaller groups. So it's pretty well-positioned with the pipeline and then on top of that, it's very well-positioned in emerging markets, as well.

Glaser: Damien, thanks for your thoughts today.

Conover: Great. Thanks for having me Jeremy.

Glaser: For Morningstar, I am Jeremy Glaser.