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Getting the Prescription Right is the problem

I like to use two approaches for valuation;
1. The Balance Sheet as the anchor; and
2. The P&L Account as the anchor.
It is a very simplistic approach. The handicap is that I miss out on
companies with no background or with a small track record in terms
of age of business.
The Balance Sheet approach is useful when it comes to looking at
companies that are predominantly in commodity businesses or in
spaces not driven by consumer spending. A simple assumption is
that entry barriers are few and businesses are prone to cycles. Here
I like to use the replacement cost as a “Fair Value”. This replacement
cost may or may not coincide with the book value, because a
business has other assets and liabilities beyond the core asset
necessary to produce the commodity. These kind of businesses are
characterised by moderate ROCE over a ten to fifteen year period,
with wild swings.
The P&L approach is applicable for those businesses that are asset
light and are dependent on consumer spending. These are
companies that have strong brands, high ROEs and no debt. You will
find them in the space of consumer products and pharmaceuticals.
Of these two, FMCG has more linear predictability. Pharmaceuticals
are a complex group. Let me try and explain why the forecasting of
a pharmaceutical company numbers or arriving at an estimated ‘fair
value’ for its shares are difficult.
Firstly, there are two distinct types. One is the pharma company that
makes dull products like bulk drugs or is in to Contract Research
Manufacture (CRAMs). These are typically low investment and low
entry barrier businesses and do not challenge us much. They are in
a sense a kind of chemical company.
There is a third set- engaged in BioTechnology, which is also an area
of intense specialisation and high level of unpredicability.
On the other hand, we have companies that invest in R&D, have
best selling products in their portfolio and have a pipeline of
discoveries that are in queue for further action. This gives a huge
unpredictability to a part of their cash flows. Similarly, they would
have products where they own the patent and some where they do
not. A new drug patent gets exploited for about ten years. In India,
this period could be shorter.
Out of 10,000 new products which get in to the R&D platform, not
more than 100 get to the stage of trials on humans and not more
than ten become best sellers later. The R&D cycle is long and there

I prefer a company with more domestic business. So. he will bite you. There are some companies where there are management concerns and I will stay far away from them. but do Still. I find the MNC pharma companies relatively safer because they seem easier to understand. The future cash flows are estimated and brought to a present value. trying to be as vague as possible. in a sense there is a high level of estimation. In addition to all this. Each pharma company may be working on some drug which has a potential to be a financial winner. Globally. MNCs typically make money by selling their globally patented drugs and OTC drugs at good margins in India. most companies spend between ten and twenty percent of their sales as R&D!! In India. This forces them to spend heavily on R&D in the hope of keeping the pipeline going. International pharma companies derive nearly 70% of their sales from patented products and thus when a product goes of patent. Once this screening is done. has an activist socialist regulator prices is easy and necessary. I have none and so my choices are limited. analysts try and forecast the future for the pharma companies! Since earnings from new products tend to be lumpy and unpredictable. fortunes of any company. India also who thinks that controlling drug far. that regulator has been a lot They have not really ruined the create noises now and then. A basically dishonest promoter cannot remain honest for too long. pricing. So of empty noise and nothing more. a degree of estimation is needed. assuming a rate of discount. since the risks of litigation. Then the spread of domestic vs global business. What I like to do is to be very careful when it comes to Indian companies.are no guarantees. At some point. I keep away from Indian companies that go on a spree of acquisition partly because I do not understand the industry enough and partly because I suspect most acquisitions. They do not spend much on R&D from the Indian Balance sheet. it is nowhere near this number. The stock that you pick could be an Indian or a MNC. I like to look at the ROE. there is a severe drop in sales and profits. forecasting etc. Hence we find that most pharma company stocks always seem expensive to us. You have to really know the industry to take a call on a player who has businesses in this industry across the globe. IP etc are lower in India. The preferred method of valuation is the “Discounted Cash Flow” or DCF. . A handful of global companies disclose fully what they are working on and a vast majority just beat around the bush.

Thus. I know this is not . Maybe it is a good option to buy a sectoral pharma fund (run the risk of manager bias) or a pharma ETF. but because of my limitations. Or else. with a far greater degree of uncertainty. The one important thing I look for in pharma companies is to make sure that the company is absolutely debt free. these are like the FMCG companies. The risk reward is not very good either. the ‘lobbying’ skills of the industry seem to be good enough to keep the government away from doing any serious damage in their zealous pursuit of afordable healthcare for all. but trusting a company with a single product is a big risk. Most of the times. If I take a snapshot of pharma companies that have a turnover of more than Rs.Pharma companies with domestic market as the main driver of earnings are what I limit my exposure to. 2015 (balakrishnanr@gmail. So far. The other thing is that they should have a wide range of products. The key is to seek established companies that have a good ROE/ROCE. no to low debt and that which derive a large part of their turnover from the domestic markets. I find that there are too many approximations in the price estimation. at the valuation highs. the pharma stocks trade at a premium to other sectors. I would like to say that we should buy pharma company stocks when the valation comes to a level where it becomes a bargain. for me to buy pharma company stocks (even those that I shortlist) means that I have to plunge in without any margin of safety. Government policies and respect for IP are other issues which can throw a spanner in the works for pharma companies. I have to back the aggression of a promoter who is talking up a good story. The sector sure does deliver above average returns over a long term. pharma does not form a significant part of my portfolio. Not because they are the best of the lot. I see that the P/E ratios are scattered between thirty and sixty! In a sense. happy hunting for those who like to own this sector in their portfolio. It is like buying a story.500 crores. R Balakrishnan October 24. So. pays a good dividend and is growing at a rate greater than the GDP. So.