Investment: Should you invest in... pharmaceutical companies?

the pharmaceuticals sector has been a source of strong growth, despite the potentially high-risk nature of a business heavily dependent on research and development of new products, and patent protection. The more mature business of chemicals manufacture has also been largely out of favour.

Glenn Meyer of Pavilion Asset Management says: "The two sectors seem to act in opposition. Pharmaceuticals are generally growth stocks and chemical companies tend to be highly cyclical. Pharmaceuticals have a much clearer and longer flow of earnings, and the chemical sector moves in line with the world economy and is much more volatile."

Jeremy Batstone of NatWest Stockbrokers has a different focus."Pharmaceuticals have been very volatile and the sector has tended to lag the market," he says. "People are looking more for value as the economy has improved, away from more defensive growth areas like pharmaceuticals."

Mark Mathias, head of investment funds at Rea Brothers Investment Management, agrees the sector's long-term growth potential is undisputed. Mathias, whose firm runs two specialist pharmaceutical funds, says: "There is the trend to ageing populations in the OECD countries, with the highest proportion of lifetime healthcare expenditure coming in the last two years of life, underpinned by the significant increase in healthcare research expenditure. At the same time, the OECD governments are trying to rein in the cost of government-subsidised healthcare and the way you do that is to spend more on drugs to keep people out of hospital."

North America's political debate about state-funded medical programmes has added to the uncertainty, says Nigel Thomas, manager of ABN Amro's UK Growth Fund. "Proposed legislation in Medicare reform will limit spending on outpatient drug costs for elderly people who account for over 30 per cent of US outpatient drug spending and this will affect pharmaceutical companies - the FT suggests it would impact earnings by between 10 and 15 per cent."

Thomas says the plans will probably not come to fruition but the debate is affecting share prices. "It is a political hot potato but given the Republican position in Congress, we are not so sure it will be enacted."

Size is also going to be a key element in future corporate earnings. "When it comes down to it, healthcare is not an optional expenditure and the amounts spent on it are going to rise," adds Mathias.

"There is very good long-term earnings visibility in the pharmaceutical sector andmergers of large companies. You can sell the same drugs into different markets, and IT helps keep control in multinational companies."

Batstone says: "There is still a lot of scope for mergers and acquisitions in the pharmaceutical sector. Critical mass is the key force driving consolidation because of the large spend on R&D. The quicker you can develop a new drug from scratch, the longer you will have the benefit of its patent protection, but without the scale you haven't got the size or funds for research."

Every major player is in the frame. "SmithKline Beecham is mentioned on a fairly regular basis but Glaxo Wellcome is also rumoured to be looking at an overseas tie-up," he adds.

Glenn Meyer says: "The UK chemical sector has underperformed the market, but overseas firms seem to value UK chemical companies more highly than the market does."

Stock selection is the key. "Concentrate on chemical sector stocks which focus on profitable areas, such as BTP, which constantly refreshes its portfolio," he says. "Avoid larger companies, which tend to underperform the market."

There is scope for the active share trader. Meyer adds: "ICI has been a relatively poor performer for a long time, but with short periods of outperformance, so timing is everything. Look at manufacturers of industrial chemicals. The problem here is that you very quickly reach overcapacity and have a fairly low return on capital."

By contrast, the bulk of investor interest in the drugs sector is focused on the largest stocks. Nigel Thomas says: "There aren't that many pure pharmaceutical companies below pounds 1bn in size. Shire Pharmaceuticals and Medeva, with Galen in Ireland, are the only mid-sized ones and once below a certain size they are largely bio-techs, of which we like Celltech and Phytopharm."

Jeremy Batstone adds: "There are a lot of stocks in the sector relatively cheap, with the possible exception of AstraZeneca. Glaxo Wellcome still looks good value at around pounds 19. We would suggest it could get up to maybe pounds 21.50 or pounds 22 in the short to medium term."

Another key player in the sector is SmithKline Beecham, where investors were holding off until the US Food & Drug Administration (FDA) ruled on Avandia, its new diabetes treatment, last week. Batstone adds: "The ruling was positive and SmithKline could be looking at sales of $1.5bn to $2bn."

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