I wrote the following note to my subscribers on a recent position we have initiated. Specialty chemicals and Pharma is currently among the few sectors which have caught the fancy of the markets. I think these sectors do have the potential for above returns in the long term, though not every company will benefit equally from the tailwind.
The success or failure of each company will come down to the unique advantages/ competencies built by the management and their execution going forward. In addition to that, each company faces idiosyncratic (fancy word for unique) risks with FDA audits being one of them.
As a result, a single company bet can lead to losses even if rest of the sector does well
In order to mitigate this risk, I have taken a basket bet approach for the portfolio. This is also due to the fact, that one cannot estimate such risks ex-ante (before the fact). Diversification across the sector reduces, though does not eliminate the risk.
Pharma Sector bet
This is different from our usual transactions. This transaction is part of a sector bet. I am betting on the pharma sector for the following reasons
- Several companies in the sector have been investing in R&D across a wide range of products such as Finished generics, API, Biosimilars and new dosage forms. As these investments have a long gestation period, the result is not fully visible in the P&L statement yet. We are now at the cusp of seeing the result of these investments, which have been made over the last 5+ years
- Several companies have been investing on the front end (marketing) for the US and other markets. This allows the company to have a better control on the supply chain (with better margins) and work directly with customers. However, building the front end takes time and we are seeing early results of that.
- The industry went through a growth phase till 2015, when it was hit by a mix of issues. The industry was hit by FDA audit failures which resulted in a loss of revenue for companies which failed the audit. At the same time, there was a consolidation of buyers (companies which buy pharmaceuticals for hospitals and pharmacies) which resulted in higher pricing pressure. This caused a drop in the growth and margins for the industry resulting in re-rating of the sector.
- The industry has since then improved its processes and has a much better record of passing FDA audits. In addition to that, companies continue to invest in these processes to improve their compliance rate.
- Several companies in the sector are now expanding beyond the US (and India) into other countries such as the EU, Japan and Africa. This should provide further growth opportunities for the sector.
We have an option to bet on a single company to play the above theme, but the risk of FDA audit and higher pricing pressures in some product segments continues to be high. I want to take advantage of this long-term tailwind and growth opportunity, but at the same time reduce the risk of failing an FDA audit. Hence my plan is to go ahead with a sector bet where we will spread out our capital across a few attractive ideas.
I have not decided the number of companies or the size of the bet yet.
The ideas in this bucket – which I will call the pharma bet (PB) could be rotated in and out with a much higher frequency compared to other positions in our portfolio. I have been studying the sector for some time now and like a few other companies in this space. My plan is to add companies some of which could be long term plays whereas others could be more tactical in nature.
