Pharma funds: Chart toppers last year, but underperformers in 2021

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Pharma funds, which invest in drug manufacturers and healthcare companies, were among the chart toppers last year.

The shares of pharma companies rallied sharply as the COVID-19 outbreak led to huge demand for healthcare drugs and vaccines.

But this year, the story has changed a bit. So far in 2021, pharma funds have delivered 21 percent as a category, which is among the lowest when compared to other thematic and sectoral schemes (see: table). Infrastructure and technology funds have given 49 percent and 47 percent returns, respectively, so far in 2021. So, what has held back last year’s top performers?

Pricing pressure in the US

US is a major source of revenues for several Indian pharma companies. It has always been a competitive market where pricing pressures were seen in the past as well.

But, this time, the pricing pressure is not just due to competition. It is also due to increased inventory levels.

Sailesh Raj Bhan, Deputy CIO, Nippon India Mutual Fund, explains that when the first wave of COVID-19 broke out, there was a fear of unavailability of raw materials for pharma companies. “So, this led to lot of inventory stocking in the US, with distributors holding stocks for 3-4 months. That inventory stocking phase continued for a six-month period. After the second wave, the inventory levels have now normalised and pricing should stabilise,” says Bhan. He manages the Nippon India Pharma Fund, which has assets worth Rs 5,000 crore.

Listed Indian pharma companies saw their shares gain significantly in the post-COVID period, as they were allowed to stay open even during the lockdown.

“It was one of the few sectors allowed to operate, given the healthcare scare. This led to positive investor sentiments, but that story has played out, pushing up the valuations,” says Purvi Shah, Deputy Vice President-Fundamental Research, Kotak Securities.

Fund managers say that the bulk of re-rating of pharma companies’ valuations happened during the first wave itself.

Remember, the sector had seen significant fall in its valuations even before the start of 2020. Between 2016 and 2019, the Nifty Pharma Index had declined 32 percent amid compliance issues raised by US’ regulatory body, USFDA, and pricing pressures that cropped up back then.

So, the sector was already under-owned before the pandemic struck. In early 2020, the sector’s weightage in the benchmark CNX Nifty 50 index was a little over two percent; this increased to 3.61 percent by the end of 2020.

In the early part of 2020, mutual funds were only marginally overweight on the pharma sector. Mutual funds had just 0.8 percentage point higher weight than the pharma sector’s weight in the Nifty 50.

But, as the sector’s importance grew post-COVID, fund managers started increasing their allocation to the sector. A recent report by Motilal Oswal shows that at the end of August, 2021, mutual funds had two percentage points higher weight than the sector’s Nifty 50 weight, which itself has increased.

What lies ahead?

Those tracking the sector say large pharma companies now have a stronger pipeline of complex new drugs.

“These new launches will help in making US revenues stable. Apart from the US, pharma companies are also diversifying into other regions,” says Vrijesh Kasera, fund manager, Mirae Asset Management Company. He manages the Mirae Asset Healthcare Fund, which is holds Rs 2,000 crore of assets.

Shah at Kotak Securities points out that new product launches come with better pricing than existing products.

However, she cautions that companies that face challenges in getting their plant approved by the USFDA, could see delays in their new product launches.

Bhan says that a few Indian pharma companies are already working in the specialty products business in the US, which is a very high-value market as against the traditional generic business.

On the domestic front, COVID-19 has raised awareness on the importance of healthcare, which fund managers say can bring behavioural changes like more willingness to visit doctors.

Pharma and healthcare fund managers now have more flexibility in diversifying their investments as, in recent years, diagnostic chains and even pharmacy chains have got listed on the exchanges. Earlier, such funds had fewer choices: domestically-focused companies, export-focused firms and hospital chains.

Further, the government’s focus on healthcare can help improve the penetration of medical facilities in smaller towns and cities.

Moneycontrol’s take

The US market has always been highly competitive, and pricing pressures are not new.

Pharma funds could offer periods of high returns and go through patches of underperformance when the sector faces challenges, through regulations or competition. Healthcare spend as a proportion to India’s GDP is low and can be an opportunity for future growth.

Invest in pharmaceutical funds only if you understand the sector well enough to take a call about its future. For those who can’t pick one sector over another or want a more holistic approach diversified equity funds are preferable.