Drugs investors should look to smaller firms

There has been so much written recently about the crisis facing the global pharmaceutical industry it is easy to forget that, for years, drug stocks were the darling of the markets, finding favour with many different types of investor.

Fund managers looking for long-term investment themes would invariably talk about ageing populations and ongoing scientific advances combining to produce ever-increasing supply and demand for new and existing drugs.

And the logic seemed to work. In particular, the second half of the 1990s saw rich pickings for investors in many drug stocks, with the industry providing excellent returns that were much more soundly based than many of those in the "dotgone" sector.

Lately however, all we see are headlines full of doom and gloom. It seems that more and more new drugs fail at the regulatory hurdle or are withdrawn soon after launch because of previously undiscovered side effects. The most commonly cited recent example is the withdrawal of arthritis drug Vioxx by Merck at the end of last month - which will cut Merck's revenues by as much as 11 per cent, according to some analysts.

The new-drug pipeline is often described as dangerously empty. Industry profit margins are under threat from governments battling with soaring healthcare costs. The growing ability of consumers to import drugs from countries with lower prices is also a threat to profitability, as are demands from poorer countries for lower-cost medicines.

As a recent report from the Boston Consulting Group (BCG) points out, all the talk of a business under threat is very reminiscent of the early 1990s, when analysts and industry insiders were warning that the global drugs business was on the verge of a major crisis. What happened subsequently provides valuable lessons for today.

We know that, in terms of share price performance at least, the industry did fabulously well. Underlying that success was, unusually, a single driver: an increase in the rate of "blockbuster" drug launches. Revenues grew spectacularly as the number of new drugs accelerated both in absolute terms and, critically, relative to the rate of patent expiry of old drugs.

Today, that process is widely thought to be going into reverse: patents are going to expire faster than new drugs are launched. Revenue growth in these circumstances is likely to be very low indeed.

Part of the pessimism is overdone: the pipeline is probably not as empty as some of the more lurid headlines would suggest. However, a lot of the drugs being developed are at the very early stage of the pipeline: even if they prove to be successful there is still a long way to go before they start to generate significant revenues.

A bigger problem, however, is that many of the new drugs are unlikely to prove to be as big a revenue generator as the blockbusters of old. It could be that the basic business model has to change.

Many industry observers are saying that the days of the blockbuster are over. Medical advances mean that many diseases are much better understood and the emerging consensus is that the new drugs will no longer be able to be sold to huge numbers of people: "targeting" is the new buzzword.

Disease, particularly cancers, attack different people in different ways, requiring varying, sometimes very specialised, treatment. For example, AstraZeneca's lung cancer treatment, Iressa, produces a dramatic improvement, but only in around 10 per cent of patients because of a genetic mutation common among that 10 per cent sub-group.

If the days of the blockbuster are drawing to a close, the pharmaceutical industry may well be faced with a stark choice: restructure or die.

Drug stocks appeal to the "growth" investor precisely because of that 1990s track record of rapid earnings expansion. They also are attractive to those of a cautious nature, offering growth in a sector relatively immune from the vagaries of the business cycle.

The logic here is that drug stocks are, in the jargon, defensive, because people will always need medicine irrespective of the wider economic climate. But share price performance over the recent past, particularly the past year or so, means that these traditional assumptions need to be revisited.

It seems that the market has been alerted to the problems that are now receiving so much publicity. The Dow Jones Stoxx Healthcare index, for example, is down around 5 per cent over the past two years, compared to a market that has risen by a similar amount.

The degree of underperformance is not huge, so it could well be that the bad news is still far from being in the price.

BCG reckons that, while the pipeline crisis is not as acute as others make out, two-thirds of the drugs in that pipeline are owned by small "biopharma" companies - which currently only make up 10 per cent of the global sector by market capitalisation.

As soon as the drugs industry shows signs of responding to these difficulties, shares will be bought on a "restructuring" play. But it seems too early to make that call.

Indeed, the underperformance of the sector may have only just started. It strikes me that most of the challenges facing the industry are, in a sense, the result of technological change. Those companies that respond with new and appropriate technologies will be winners: but the identification of those success stories looks, for the moment, to be just as big a lottery as choosing winners from the technology sector.

The European drugs sector is trading at the same level seen in 1997. It has been up and down in the interim but has essentially gone nowhere for seven years. It is tempting to argue that, given the barrage of negative publicity affecting the sector, it must be due for a bounce.

However, it seems to me that any good news, particularly about drugs in the pipeline, is likely to emerge from smaller companies and that it would be best to avoid the big boys - the likes of Roche, Novartis and AstraZenca - for a while longer.

Biotech and genomics are two labels attached to the smaller companies and those sectors are nowhere near as dead as some commentators have suggested.