3 things to keep in mind before investing in the pharmaceutical sector

Before you invest in companies related to the pharmaceutical sector, you should read the following article. The 3 key take ways from this article are:

  1. The barriers to entry the pharmaceutical sector are very high, giving the existing companies a competitive advantage.
  2. Expiring patents reduce the barriers to market entry that existed in the past and offer smaller companies growing potential at a fraction of the patents’ development costs.
  3. Rising life expectancy coupled with the growing middle class in emerging markets has great potential for sales.

Basic understanding of the pharmaceutical sector

Before choosing an investment in the pharmaceutical industry, you should get to know it better. Thus, in the following you’ll get a basic overview of the pharmaceutical sector.

The pharmaceutical industry includes companies involved in the manufacturing and development of prescription drugs and over-the-counter products that are used to prevent illnesses in humans or animals.

The pharma sector is dependent on 5 factors (Source):

  1. Disease prevalence is related to population size, age, genetic inheritance and behavior
  2. Affordability is related to income but also to drug prices.
  3. Consumer attitudes include willingness to use alternative therapies or distrust of taking drugs.
  4. Government (and insurance company) policies affect reimbursement and who the payer of drugs is. Other government policies determine regulation, which can be a significant barrier to the launch of new treatments.
  5. A major supply-side factor is availability of an appropriate treatment, which may be a matter of quantity, as in an epidemic, or of drug discovery and development.

In 2017, the value of the global pharmaceutical sector was $934.8 billion, a growth of 5.2% per year from the years before. The forecast for 2021 estimates an increase in growth of about 5.8% per year, rising the worth to $1,170 billion in 2021. Pharma sales in Asia Pacific will grow at 8.4% a year to 2021.

In comparison, the other two large healthcare sectors, namely medical equipment and healthcare service, will grow with 7% year on year. (Source) Overall, the positive growth of 5.2% per years is a very good signal for investing in the pharmaceutical sector.

The largest sales market for new drugs in the last 5 years was the US with a share of 64.1%. The reason for this is that most drugs are produced in the US and therefore approved first localy. Worldwide approval is expensive and involves regulatory and judicial costs. 18.1% of new medicines were sold in Europe between 2012 and 2017.

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Looking at not only the newly approved drugs, but the total worldwide sales, we see a more balanced picture. In 2017 the largest market was still the United States together with Canada. In North America, 48.1% of the world’s medicines are sold. Followed by Europe, with 22.2% of global sales,  Africa, Asia and Australia with 17.0% and Japan with 7.7%. In South America, 5.1% of the world’s medicines were sold in 2017.

Source picture

Purley by looking at the information above, we could infer the following: in the US and Canada the majority of newly approved as well as established drugs are sold. Thus, we might rather invest in pharmaceutical companies that sell a large part of their products in those  markets. Doing so, we ensure that the companies we might be invested in might be more likely to maintain revenues.

Spending on drugs per GDP

Closely linked to the information above, we now look at the societies’ spending on drugs compared to their countries’ GDP.

The fact that a lot of pharmaceuticals are used in the US is becoming a financial problem for many Americans. The figure below shows the trend in expenditure on pharmaceuticals relative to gross domestic product (GDP) between 1980 and 2016. Over the 26 years under review, this ratio has more than doubled in the USA. From the figure, it is clear that the US has by far the largest ratio in 2016. It is therefore not surprising that the government under Donald Trump is campaigning for lower prices for pharmaceutical products. In Europe and Japan, the ratio of expenditure on pharmaceuticals to GDP increased by an average of 75%. (Source)

Expenditures on pharmaceuticals relative to GDP

Top 10 largest companies in the pharmaceutical sector

The chart below shows the largest 10 pharmaceutical companies in terms of sales in 2017. Largest company is US-based Pfizer ($ 45,345M) followed by two Swiss companies: Novartis ($ 41,875M) and Roche ($ 41,732M). Six out of the top 10 pharmaceutical companies are headquartered in the United States. There are 2 companies from Switzerland, 1 from France and 1 from the UK. If you want to invest in the pharmaceutical sector I would recommend to invest in one of the top 20 companies depending on the company valuation (click here for a complete guide to company and financial analysis).

A large part of the company’s earnings is spent on research and development. In 2017, Roche had the largest spendings in this area with $ 9,181M. In 2017 the top 10 pharmaceutical companies invested on average 18.58% of their revenues in research and development. Source

PESTL analysis for the pharmaceutical sector (focusing on the USA)

After we’ve seen so far, US based pharmaceutical companies might be a good investment opportunity. However, let’s take a closer look at the United States and see if those pharmaceutical companies are a good investment.

We can use the PESTL analysis as a tool used to analyze and monitor the macro-environmental factors that impact the pharmaceutical sector. Since the majority of the largest pharmaceutical companies is based in the US, the following PESTL analysis will focus on the US as well. Let’s look at the 5 factors that a PESTL analysis considers…

Political factors

The government is prohibited from directly negotiating drug prices for Medicare Part D, resulting in substantial policy debate. Therefore the federal government imposes additional $84.8 billion in taxes for pharmaceutical companies. Further, it discounts Medicaid and Medicare patients in exchange for the limited ability to bargain drug prices and to reduce drug prices after several prices raised in extreme manner (2015: Daraprim + 5555%, 2016: EpiPen +500%)

  • Medicaid: Medicaid is a means-tested health and medical services program for certain individuals and low-income households with few resources. Primary oversight of the program happens at the federal level, but each state is responsible for: establishing its eligibility standards, determining the type, amount, duration, and scope of its services, setting the rate of payment for services and administering its own Medicaid program (Source)

  • Medicare: Medicare is the federal health insurance program that pays for hospitals and medical care for: People who are 65 or older, certain younger people with disabilities, people with End-Stage Renal Disease (Source).

Economic factors

The pharmaceutical industry is highly globalized with 15 multinational companies that dominate the industry. But companies in emerging markets like China, Brazil, and India provide low-cost, brand name pharmaceutical drugs to the US market that may impact competition. Low-cost drugs have a high potential due to the high spending on drugs relative to GDP in the United States. To compete with low-cost pharmaceutics multinational companies begin to outsource labor and research to reduce costs and are therefore able to compete.

Another economic factor is the growth of GDP in emerging markets. The rising middle class will be able to buy drugs as new customers. Especially in China and India the GDP grows with about 6% annually, making the rising middle class more and more solvent, able to buy drugs.

Social-cultural factors

There are two major trends in the social-cultural space. Both will increase the demand for more and more pharmaceutics in the future. First, the percentage of the older generations of total society is increasing. Second, the average life expectancy is increasing as well. Therefore, higher demand for prescription drugs is expected, amongst others due to the greater prevalence of chronic ailments. Overall, in emerging markets we will see an increasing demand for low cost drugs as alternative to brand name drugs. Also more and more people want to live in cities. The high levels of urban pollution increase the incidence of conditions like asthma, which must be treated with medication in most of the times.

Technological factors

The development of new drugs is associated with great effort. That’s because over years, individual development steps must be successfully completed so that a drug is approved for people to use. The figure at the end of the paragraph shows a schematic diagram of the life cycle of a drug, including its development. Development starts with patenting in year 0. The first 10 years are pure research and development, which is divided into a pre-clinical phase and a clinical phase.

In the pre-clinical phase, the potential drug is tested for potential adverse effects. Toxicologists investigate whether (and if so, at what concentration) the drug candidate is toxic, whether it damages embryos, causes cancer or causes genetic alterations. Some of these can be tested “in a test tube” or with cell cultures, but others can only be studied on whole organisms. That’s why certain experiments with at least two species are also required by law.

The clinical development is divided into 3 parts (Source):

After 10 years of research and development, 2 to 3 years of administrative processes follow. So it can take up to 13 years for the drug to be sold. It is important to note that the patent protection is eliminated after 20 years and thus other companies may use the same active ingredients by then.

Due to the large effort, the long time span and the resulting large financial expenditure of an average of $ 1.2 billion for the first 10 years, it is not surprising why the development of blockbusters is limited. Moreover, only 2 out of 10 marketed drugs generate enough revenue to cover initial costs for development.

By the way, blockbuster drugs are drugs that generate at least $ 1 billion in sales a year. Some famous blockbuster drugs are Vioxx, Lipitor or Zoloft.

Legal factors

US based pharmaceutical companies might suffer from the attempt to repeal the Affordable Care Act. This would affect 20 million insured patients and would hurt overall drug sales.

However, there are also positive legal aspects benefiting the pharmaceutical sector. For example, the time for approval confirmations has dropped from 356 days in 2007 to 170 days in 2016 (Source).

Porters 5 forces applied to the pharmaceutical sector

The rivalry between the largest companies in the pharmaceutical sector is huge. The 4 largest companies create 40% of total sector revenues. As the development of new medicines takes a long time and costs a lot of money, M&A activities are forced to drive growth and increase market share. In addition, patents can be won through acquisition. Larger M&A activities of recent years are Pfizer-Wyeth, Merck-Schering-Plough, and Roche-Genentech.

To make sure that a pharmaceutical company is a suitable investment case, let’s look at Porter’s 5 forces:

Power of the buyers

The power of buyers is low to not existing because there are no or only very few alternative drugs due to the long development process. If a company increases the price of a drug, the customer has to pay the higher price, see for example the price increase of 500% of EpiPen.

Power of the sellers

The power of sellers is very high because research, development, production and sale is entirely controlled by the pharmaceutical companies. The only limits set for drug sales prices is by health insurances and the federal government.

Threat of new entrants

The threat of new entrances into the industry is quite low, simply because there are high market barriers. That’s mainly because research and development costs are very high and have to be financed for many years before the first revenue is generated. The figure below shows the R&D expenditures of pharmaceutical companies in Europe, USA and Japan over the years 1990 to 2016. Startups need to be highly funded to successfully enter the market. In addition, the knowledge of pharmaceutical products and their development is very centered in the individual large existing companies.

Threat of substitutes

The thread of substitutes is high when patents expire. By then, the individual product is no longer protected, so more companies can launch a drug with the same ingredients without the high research and development costs. Copies of patent-expired drugs are so called Generics. The figure on the right shows that Generics have a high market share in developing economies where governments are encouraging their production in order to make lower-price treatments more widely available.

Based on Porter’s 5 forces one thing becomes clear: the pharmaceutical industry is quite an attractive sector to invest in. First, that’s because of its high barriers to entry that protects the current incumbents. Second, pharmaceutical companies have huge power over its drugs’ prices. Of course, there’s also the threat of substitutes. Overall, however, the most successful pharmaceutical companies exhibit quite a strong market positioning.

Final Thoughts on important things to keep in mind before investing in the pharmaceutical sector

There you go: I have told you about the major characteristics and developments of the pharmaceutical sector. Now you know about the industry’s main driving forces and shifts expected in the future. This information is key to select suitable pharmaceutical companies to invest in.

Again, keep the following 3 points in mind:

  1. The barriers to entry are very high, giving the existing companies a competitive advantage.
  2. Expiring patents reduce the barriers to market entry that existed in the past and offer smaller companies growing potential at a fraction of their development costs.
  3. Rising life expectancy coupled with the growing middle class in emerging markets has great potential for sales.

Now I would like to hear from you..

Which stock of the pharma sector are you going to analyze or buy first? Do you think you will find some good investment opportunities?

Either way, let me know by leaving a comment below right now.

Thanks for reading this article. Please, let us know if you have feedback, corrections, or any further question (either down below in the comments or via contact). We are happy to discuss and further support you along your way to becoming a “yield reviewer”.

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