Visibility improves at end of the drug pipeline

Serious Money: Visibility is one of those words bandied about by investors that can mean different things to different people. And, like many stock market terms, it is often used as a code word for something else, as a way of being quite rude about a company's prospects without being terribly explicit.

Most of us would, I guess, think it refers to the probability that we can attach to a company's earnings stream. When an analyst says that a firm's profits have low visibility, he usually means either that we don't have a clue, or that we should be preparing ourselves for some very bad news.

Indeed, most stock market references to visibility are in the negative: I reckon that, for every company that is described as having increased visibility, there are at least 100 where it has been reduced.

The sorts of businesses that have high earnings visibility, relatively speaking at least, are often utilities. These are companies that usually have highly predictable and stable earnings and cash flows. Indeed, the people whose job it is to define these things often describe utility companies in precisely these terms. And utilities often have profits that are regulated, defined sometimes in terms of an allowable return on capital.

One group of companies that used to have high earnings visibility is the drugs sector. We used to think of these businesses as providing products into a marketplace that was increasing over the long term thanks to ageing populations and technological change. Not only do older people demand more of existing treatments but the invention of new drugs tends to create more demand: diseases that had no cure suddenly become treatable (hopefully).

Owning the shares of pharmaceutical companies for the whole of the 1990s was like shooting fish in a barrel.

It helped, of course, that not only were drug stock earnings highly visible, but they also grew rapidly. The tendency for pharmaceutical companies to buy each other also helped. Growth, visibility and potential for a bid: an investor's dream.

But since 2000, until this year at least, owning drug stocks, particularly of the European kind, has not been a particularly profitable thing to do. What has gone wrong? And does the renaissance seen in some pharmaceutical share prices suggest the start of another long-term bull market? Household names like Glaxo and Roche (in particular) have been having a stellar year. Can it continue?

Some explanation for why drug stocks did so poorly is clearly in order. Nothing much has changed by way of the underlying demand story. If anything, the global ageing bit of the picture has become an even stronger argument for exposure to the sector.

Arguably, drug stocks became sucked into the stock market madness at the end of the 1990s and, like most equities, were just part of a general bear market until things started to stabilise in 2003. We haven't had big drug company mergers at anything like the rate seen during the 1990s, so that catalyst for share price performance has been missing.

Markets have clearly begun to distrust, or lose faith in, the drugs "pipeline" story. Pharmaceutical companies traditionally have relied on blockbuster drugs, developed and tested over many years before launch. Until 2000, investors were happy to assume that the steady supply of new blockbusters would continue, even if we were never quite sure what they were.

Since then, a number of things have happened to persuade markets that such trust is misplaced.

It would not be too much of an exaggeration to suggest that drug stocks are now viewed by the market as something of a cross between technology and tobacco stocks. Technology because of the characteristics shared between any companies that rely so heavily on the fruits of R&D spending. And just as the market lost its faith in tech stocks, so it began to suspect that indiscriminate approval of pharmaceutical companies R&D programmes needed to be revised. Pharmaceuticals are like tobacco because of the risks from the regulatory and legal systems when things go wrong (think Merck and Vioxx, for example).

Some in the industry fear that the blockbuster model is broken. It is becoming apparent that we can all get the same disease but react differently, requiring different treatment, thanks to genetic disparities. Biotech is reckoned by some to be on the verge of its own renaissance thanks to the growth of "targeted" treatments. Tailored drugs, best suited to our own genetic make-up, are thought to be the future. If so, the role of one-drug suiting all blockbuster treatments is questionable at best.

The market's obsession with free cash flow generation has not helped either: we have just lived through a period when investors have been prepared to reward profits, particularly in the form of hard cash paid out today (as opposed to airy-fairy earnings), rather than vague promises of jam tomorrow. Stories about cash being generated by drugs that may be approved in several years' time have not been listened to.

There are hints - but only hints - that some of this is changing. Investors are realising that future growth prospects do have value. And drug companies are all about the future.

Nevertheless, one of the drivers of share price performance in the drug sector has still been about the short-term.

Stocks have gone up (and sometimes down) because of stories about the prospects for near-term cash flow generation. Roche has had several drivers this year, but tamiflu (the drug in short supply because of Asian flu worries) has been one of them.

Glaxo, arguably, has had a good year because there is a growing recognition that it might have a decent long-term story with regard to is drug pipeline.

All of this adds up to the simple observation that earnings visibility for the drug sector is poor - and that is unlikely to change. A 1980s style share price performance is unlikely to make a comeback.

But the turnaround in stocks like Glaxo and Roche this year does look hopeful: they are precisely the kind of companies that belong in most long-term portfolios.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.