Pharma Slide: Valuations Versus Growth Risks

Pharmaceutical stocks corrected on Monday after correcting for the better part of the last 12 months as well. While the Sensex has gained around 21 percent in the last one year, the Nifty Pharma Index has declined about 8.7 percent in the same period. Individual stocks have declined further, with the top 3-4 companies falling in double digits in the corresponding period.

One of the possible reasons for Monday's correction could be a report from brokerage house Credit Suisse. The report says structural concerns for Indian drugmakers in the United States have increased further, with the U.S. generic market deteriorating faster than previously expected. The brokerage sees multiple de-rating triggers, mainly on increased competition and pricing aggression by late entrants in the U.S. Credit Suisse already had arguably amongst the lowest price targets on the Street for pharma stocks and has cut prices further.

One must argue though, that the valuations are benign. The pharma index is significantly off the peak reached in April 2015. And most stocks trade under 17 times financial year 2018-19 price-to-earnings, as per Bloomberg consensus earnings estimates. The bears see lower growth, resulting in more expensive valuation projections – around 20-21 times FY19 estimated earnings.

But it's not as though everyone on the Street is bearish on the sector. Big bull Rakesh Jhunjhunwala, in a recent interview with CNBC-TV18, believes that the sector is near a bottom and that growth rates could be better than what the markets are predicting. The seasonality factor is working in favour of large pharma companies. The month of June has given positive returns in each of the last four years for Lupin Ltd., with 2014 yielding 12 percent and 2016 yielding 4.4 percent. Dr Reddy's Laboratories Ltd. too has given positive returns in June in each of the last four years, with returns being just over 6 percent every year except 2015 when the stock was flat. Sun Pharmaceuticals Industries Ltd. has not had such a good run in June, with divergent returns every year, and flat trade in June 2016.

Sentiment on pharma has not been so bearish in quite a while. And big money is made when invested during periods of fear. Will the rest of market come around to seeing the space the way Rakesh Jhunjhunwala does?

Niraj Shah is Markets Editor at BloombergQuint.