John Stephenson, portfolio manager and president of Toronto-based Stephenson & Company Capital Management Inc., says that drug spending is unlikely to outpace the growth of other healthcare costs in the United States. The drug-pricing model may need a little recalibration, but this shouldn’t detract from the amazing progress in the field. The golden age of drug development is here and he picks three pharmaceutical stocks to profit most from it.
Markets seem to have turned the corner lately, with the major U.S. indices and the TSX ending May higher. Investors’ new expectations for the pace of U.S. interest rate increases changed the complexion of the markets in May, with many pivoting from worries that rising rates would hurt stocks to embracing them as a sign of a more robust economy.
Midway through the month, major U.S. indices gave up much of their gains for the year, after improving U.S. economic data and comments from Federal Reserve officials signaled that a rate rise could come as soon as June. But in late May, investors’ changed their views once more and became more constructive on the likely path of interest rates in the world’s largest economy.
Despite the improving global markets, pharmaceutical stocks have been under pressure lately, with biotechnology stocks getting especially hard hit. While Valeant Pharmaceuticals is the poster boy for its aggressive management of drug prices, the sell-off in the sector seems a little extreme. After all, pharmaceutical companies have made breakthroughs in treating and even curing diseases, ranging from hepatitis to multiple sclerosis and with new drugs, such as those for cancer.
The most promising of these new medicines can cost upwards of $1,000 a pill or some $150,000 a year, sparking a backlash from consumers, lawmakers and healthcare systems. The push-back from lawmakers, coupled with the market turmoil, have pushed the median price/earnings ratio for large capitalization pharmaceutical stocks down to 14.7 times from 18.1 times a year ago. Also weighing on the valuations in the sector are the proposed mergers of Aetna-UnitedHealthCare and Cigna-Anthem, both of which are awaiting regulatory approval. These may shift the once- fragmented U.S. payer market closer to an oligopoly.
The fight against cancer
One of the most promising areas of pharmaceutical research has been in cancer treatment. Cancer killed 8.2 million people worldwide in 2012 and some 22 million cases a year are expected by the 2030s, according to the World Health Organization. Cancers develop when a group of cells that are growing unchecked learn to evade the body’s immune system.
Recent breakthroughs have shined a spotlight on a field of drug therapy called immuno-oncology (I/O). With this therapy, drugs work by harnessing the body’s own defense system to attack cancer cells. Two leading drug companies, Bristol-Myers Squibb and Merck, have pioneered the research, development and commercialization of immuno-oncology drugs. But what’s next?
Researchers think there could be tremendous possibilities in combining immunotherapies with one another, other targeted drugs, or chemotherapy. Key clinical data are on the horizon, with pharmaceutical companies seeking to increase long-term survival rates among patients and make immune-oncology drugs work against a variety of tumors, such as those in breast and prostate cancers.
One worry that is keeping the lawyers at pharmaceutical companies hopping is a slate of copycat drugs known as biosimilars, as legal action must be taken against the companies that produce them.
These biosimilars are cheaper versions of biotechnology drugs, a big challenge for established pharmaceutical companies. In Europe, these copycat medicines have undercut the price of the original, branded versions by 20 per cent to 30 per cent, and posing a major threat to more than $190 billion in drug sales through 2025.
But this kind of innovation is expensive, and drug-makers rely on high prices to bolster their profit margins. In the U.S.—the number one drug market and a key focus for global pharma and bio-tech companies— Big Pharma has become a topic in the 2016 presidential campaign. The industry is particularly sensitive to perceived threats on pricing, and the sector crashed after Hillary Clinton’s “price gouging” tweet in September of last year.
The Republican Party’s presidential nominee, Donald Trump, was hard at it in February, blasting drug companies and vowing to renegotiate the prices that Medicare pays for drugs, all the while suggesting that lawmakers have become beholden to drug companies. The tough-talking New York businessman went on to say, “the drug companies probably have the second- or third-most powerful lobby in this country. They get the politicians, and every single one of them is getting money from them.”
Donald Trump and other presidential candidates have called for Medicare to be able to negotiate its own drug prices, among other price control measures. Yet such an initiative would require congressional support, which seems unlikely in such a divided congress.
Politicians love headlines and focusing on list prices gives them the attention that they crave. But the actual price that is negotiated between drug-makers and payers behind closed doors is often considerably less than the list price. The reason why drug prices are rising is that science has delivered demonstrable benefits from these new medications. Hepatitis C is a curable disease, HIV patients live near-normal life spans, and cancer may be on the cusp of becoming a chronic condition.
The historical model for pricing new drugs uses the relative benefit of a new drug over the then-current standard of care as a proxy for setting its premium. The bigger the benefit from a new drug the higher the premium it can command.
But all of this obscures the reality that the cost of drugs is small when compared with other costs in the U.S. medical system. The prescription drug component of Medicare (Part D) accounts for a scant 11 percent of total outlays, and actuaries at the Centers for Medicare and Medicaid Services estimate that drug spending is unlikely to outpace the growth of other cost centers in the future. The drug-pricing model may need a little recalibration, but this shouldn’t detract from the amazing progress made in the field of medicine. The golden age of drug development is here.
What I recommend
The pharmaceutical industry offers unquestionable value from both an investment and medical perspective. The current weakness in the share prices offers investors a unique opportunity to increase their exposure to a sector that will benefit from an aging demographic which demands, and will pay for, innovative and targeted drug therapies.
One company that I like is Bristol-Myers Squibb Company (NYSE─BMY). Bristol-Meyers Squibb is a leader in the development of immuno-oncology medicines (I/O). Collectively, I/O medications could generate as much as $24 billion in sales in 2020, thanks to a particularly promising class of I/O drugs, called PD-1/L1s, which disables one of the mechanisms used by cancerous cells.
Bristol-Myers Squibb’s Opdivo was one of the very first such drugs of this type on the market. New data from Opdivo and the company’s other leading I/O drug, Yervoy, should dominate the headlines in 2016 as important data sets from drug trials are released, putting more distance between the company and its rivals.
I have a Buy rating and a twelve-month price target of $80 per share on Bristol-Myers Squibb.
Gilead Sciences Inc. (NASDAQ─GILD) is a bio-tech stock that I really like. The company ranks as the largest biotechnology in the U.S., and its market value of $131.3 billion rivals some large pharma companies. The company has proven to be remarkably agile, demonstrating the ability to reinvent itself to pursue profitable opportunities. During much of the past decade, its best-selling products were the five drugs on its HIV roster: Viread, Truvada, Atripla, Complera, and Stribild.
The launch of the hepatitis C drugs Sovaldi in 2013 and Harvoni in 2014, however, dramatically improved the company’s fortunes. By the end of 2015, Gilead’s annual sales totaled $32.6 billion, compared with just $11.2 billion in 2013. I have a Buy rating and a twelve-month price target of $110 per share on Gilead Sciences.
Another solid name that I like is Merck & Co. Inc. (NYSE─MRK). Merck is working hard to catch Bristol-Myers Squibb’s lead in I/O, with the company now boasting a 29 per cent share of all patients enrolled in immuno-oncology trials. The company also has a strong lung cancer franchise, with a better share of enrollment for this type of cancer than Bristol-Myers Squibb. I have a Buy rating and a twelve-month price target of $65 per share on Merck.
While there’s always a risk of further pressure on the sector, especially with the U.S. election season about to begin in earnest, the valuations and the possibility of substantial earnings growth look very attractive. Investors should consider slowly building positions in some of their favourite pharma and bio-tech stocks as the bottom has most likely been put in.
The MoneyLetter, MPL Communications Inc. 133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846