Chief Investment Officer outlines why some pharma companies have struggled while others have soared and one might even be joining the 'magnificent seven'
Eli Lilly’s stock has done so well this year that it might replace Tesla in the magnificent seven. The mega-cap pharmaceutical company is up almost 28 per cent year to date and is up over 126 per cent over the past 12 months. The electric car company, on the other hand, is down over 20 per cent YTD. A full-on ‘replacement’ might be more the subject of memes and speculation now, but the rise of Eli Lilly points to a few major trends in pharmaceuticals that institutional investors and asset managers need to be aware of.
Eli Lilly’s rise, notably, has not been mirrored by all of its fellow big pharma leaders. Pfizer, another huge pharmaceutical name and the primary beneficiary of the COVID-19 vaccine race, is down almost 8 per cent year to date and down more than 36 per cent over the past 12 months. We see similar bifurcation between another pair of competing pharma companies: Merck is up this year, while Bristol-Myers Squibb is down. So why are these massive companies, known for their stability and capitalization, diverging so much right now?
“When I think about a pharma company as a business I want to invest in, I look at how well run the company is, what their culture is, and what everybody gets for each dollar they invest in R&D,” says Paul MacDonald, Chief Investment Officer at Harvest ETFs. “When I think about what drives pharma companies to perform differently, it’s really a combination of that corporate culture, execution, R&D productivity and a little bit of luck. The big divergences happen when the science starts to work better for one versus the other.”
That story has played out so far this year in the stock valuations of companies like Eli Lilly, Pfizer, Merck, and Bristol-Myers Squibb. MacDonald notes an element of luck in Lilly’s story, given their success in developing GLP-1 drugs that can be used to treat both diabetes and obesity. MacDonald, who manages Canada’s largest US Healthcare ETF, expects that market to be worth over $100 billion by 2029.
There is now a large amount of investor hype around GLP-1 drugs, similar to the excitement over AI we saw on stock markets last year. However, MacDonald sees underlying numbers and industry dynamics that justify the stock’s current valuation beyond just investor sentiment. Eli Lilly is currently showing long-term growth of 30 per cent earnings per share, commanding an earnings multiple of 60x. The stock may look expensive, but right now Eli Lilly appears to be the preferred manufacturer of GLP-1 drugs by US insurance plans. As we understand which drugs those plans, and Medicare, will cover, earnings should rise and that multiple should come down.
Beyond just GLP-1 drugs, MacDonald sees “shots on goal” across Eli Lilly’s R&D portfolio. There are drugs in immunology and oncology that show real promise, as well as potential game-changing innovations on the treatment of Alzheimer’s. These developments have put Eli Lilly far ahead of their fellow big pharma firms, at least from a valuation standpoint.
Pfizer, conversely, has struggled with R&D productivity as many of their products hit a “patent cliff” and went generic in recent years. The cash windfall they received from COVID-19 vaccines has now largely been consumed and many of the acquisitions they made to backfill their R&D “pipeline” haven’t panned out as well as they might have hoped, resulting in a weaker valuation. The R&D success of Pfizer, per dollar spent, is now significantly lower than other companies on the market.
Merck and Bristol-Myers Squibb have also diverged on the back of different R&D outcomes. The two companies now directly compete in the realm of immunotherapy. Merck’s Keytruda has generally been more successful than Bristol-Myers’ Opdivo introducing that element of direct competition into their relative valuations.
While we sometimes see divergence in performance between pharma stocks when they hit a patent cliff — most recently in 2015-16 — MacDonald says the current spread is around the widest he’s seen in his career. Corporate performance explains some of that gap, some companies have simply shown themselves to have stronger earnings, better balance sheets, and faster growing market share. He also notes, however, that many big pharma companies spun off their consumer products divisions over the past decade. Those divisions were stabilizing influences on earnings, less tied to the successes and failures of scientific research. Pharma companies’ valuations are now more directly subject to their R&D outcomes.
The current state of pharmaceutical R&D may present one opportunity for institutional managers and pension funds in the acquisition of small, private research companies. Companies lagging behind their competitors on research may look to make more acquisitions, while the winning companies may have cash to spend on small innovators. Those companies, too, are moving at something of a discount given the increased cost of capital. Asset managers capable of providing liquidity and funding to these research companies, MacDonald says, will have a leg up in turning them into saleable assets that big pharma may be interested in.
From an asset allocation standpoint, the diverging performance of pharma companies has made the subsector into a stock-picker’s market. MacDonald, though, advocates for diversity of exposure despite these diverging dynamics, because of how quickly scientific research can change the outlook for a company.
“Success on the scientific side can happen very quickly, and leadership can change very quickly on the back of those successes,” MacDonald says. “I would suggest diversification so you can step back and take into account not just the diversification but also the cross-pollination of indicators and treatments.”
