Personal finance: The world will always need pills

Investment news from the Motley Fool

DOES valuation matter any more? As the stock market marches relentlessly higher, so too do some of the valuations afforded a relatively narrow range of companies. Most of us have heard how Rupert Murdoch, Bill Gates and Alan Greenspan have labelled internet shares overvalued but the phenomenon is not confined to the "dot com" stocks.

The pharmaceutical sector has been on fire over the past 12 months. The share prices of the big three drug companies, Glaxo Wellcome, SmithKline Beecham and Zeneca, have been driven higher mainly because of hopes of consolidation within the sector.

The first two companies have already aborted merger talks and the latter company will soon be re-named AstraZeneca following ratification of the merger with its Swedish counterpart.

Investors hope pooling resources at these already massive companies, particularly in the research and development area, will lead to considerable cost savings. It's a case of hoping that 1+1=3.

Business school theory will teach you that, over the long term, a company's share price will rise in line with the company's profit growth. So much for the theory - the recent share price appreciation of the pharmo-three has occurred despite 1998 being a year where total profits will shrink.

However, there is some method to the madness - the stock market is always looking forward. In 1996, despite growing profits by 16 per cent, Glaxo Wellcome's share price showed little appreciation. This is because the market was concentrating on the imminent patent expiry of its block-busting anti-ulcer drug Zantac.

Two years down the track and Glaxo is in post-Zantac mode. The market has seen that Glaxo has a strong drug pipeline, which should fuel profit growth in the future. Despite profits falling in 1998, the share price has flown.

After all, as the population ages, the demand for its products can only increase. Drug sales to countries such as India and China are currently inconsequential, so these could be huge growth regions and the pharmo- three are virtually recession proof. When consumers are forced to tighten their purse strings, spending on medication is the last thing they will forgo.

Compare this with Lasmo, an oil exploration company. It is heading towards a loss for 1998 for the third year out of the past six. The returns for the industry are largely governed by the underlying oil price, something over which Lasmo has no control. It has no pricing power, operates in a very competitive market and requires large outlays to go about its business, often with no guarantee of success. It is little wonder that Lasmo trades at a market value that is less than the sum total of its assets.

One of the lessons that Warren Buffett learned in his early investing career is that the quality of company matters - a lot.

Buffett attempts to buy part interests in quality companies at what he considers attractive prices. In these go-get-'em days, the great man himself may be finding value a little difficult to find.

But he certainly wouldn't be buying shares in a company like Lasmo, whatever the price. On the other hand, because of the predictability of earnings and the quality of business, the big drug companies would be much more up his alley.

www.fool.co.uk

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