The best British big pharma stock to buy now

Yesterday, stock markets just wanted to ‘believe’.

The eurozone deal had been done. And we learned that US GDP grew at a 2.5% annual rate in the third quarter, almost double the previous three months. Any bad news was ignored. The FTSE 100 climbed 2.6% while European markets jumped some 6%.

But don’t be fooled. As my colleague John Stepek pointed out in yesterday’s Money Morning, economies in Europe – and indeed the world – aren’t cured yet.

So we think you should stick to investing in ‘defensive’ stocks. For one thing, they don’t need economic growth to make their profits. For another, several defensives offer inflation-matching yields.

Britain’s ‘big pharma’ stocks are a good example. But if you’re not already invested in the sector, which is the best share to buy now?

Healthcare stocks look good value

Regardless of how weak the global economy is, people around the world will need to spend money on healthcare, as we’ve discussed several times before. That’s why global ‘big pharma’ firms have been able to generate ever-increasing streams of profits and cash flows.

So, you’d have thought the sector would be a popular one with investors. Yet over much of the last decade, big pharma has fallen out of favour. Stocks in the sector have been savagely de-rated. In other words, their p/e ratios have tumbled as investors have placed less value on these companies’ future earnings.

Why? There are risks surrounding big pharma, such as lawsuits over defective products with nasty side effects. But the main worry for investors has been the so-called ‘patent cliff’.

Many former blockbuster drugs either have lost, or will soon lose, their patent protection. That means these medicines can then be copied by ‘generic’ rivals and sold on the cheap. In turn, there’ll be less profit to be made from these products.

Indeed, between 2011 and 2016, $255bn-worth of annual sales of the world’s top-selling drugs will go off patent, says researcher EvaluatePharma. That compares with global industry revenues of $880bn. That doesn’t sound too promising. So why would the big pharma sector appeal to investors now?

The patent cliff is in the price

Here’s why. The patent cliff might be steep. But it’s also an extremely obvious problem – you can see it coming from miles away. As a result, by now it has been fully ‘discounted’, ie, it’s well and truly baked into the share prices of major drug makers.

And all the while that investors have been fretting about this patent cliff and shunning the sector, big pharma’s earnings have been growing, and its dividend payouts have too. Along with lower share prices, this means the sector now contains both cheap stocks and some well-above-average dividend yields.

There’s more good news, too. The big drug companies have been steadily dealing with those lawsuits we mentioned earlier. They’re also taking action to offset potential patent cliff damage to their sales. They may have been trading water on the replacement drugs front in the past. But now they’re getting their act together in stepping up the search for new blockbuster medicines. They’re also diversifying into areas like vaccines, and looking for new places to sell their wares.

And here’s where we come to this week’s big pharma news. UK giant GlaxoSmithKline (LSE: GSK) has just announced its 2011 third-quarter results. Underlying sales grew 6% while earnings before restructuring charges were also up. But the real message was in the outlook statement.

GSK boss Andrew Witty has been shifting the firm’s drug portfolio away from relying on “white pills in Western markets”. There’s now much more focus on consumer healthcare and developing economies. Sales outside America and Europe grew by 17% in the third quarter and now account for 38% of overall revenues.

More of the same is in store. Sure, there may be some short-term economic wobbles. But Mr Witty says that in the long run, he’s “an extreme bull” on emerging markets because of their growth potential.

And GSK is happy to show its confidence in the future. The long-term share buyback programme is continuing: the company spending its own money on its shares is a good sign for other investors. But rather more important for small shareholders is the latest hike in the quarterly dividend.
The payout is being lifted by 6% to 17p per share. That puts GSK on a 5% prospective yield for 2011. And if history is any guide, there’ll be a similar increase next year, which would lift the yield to around 5.2%.

Not bad. However, while GSK has been one of our favourite big pharma shares for a while – it’s up 15% since we tipped it in February – on a p/e of more than 12 for the current year, it’s a bit pricier than it was. So while I’d be happy to hold it, I reckon there’s even better value elsewhere.

Rival AstraZeneca (LSE: AZN) also turned in third-quarter figures this week. Sales in US dollars – the firm’s accounting currency – were up 4%, while earnings per share increased by 14%.

Again, the company is working hard to grow its product portfolio. And while Astra doesn’t pay quarterly dividends, analysts expect that the full-year payment will be lifted by around 6.5%.

That would put Astra on a prospective yield of almost 5.7%. The 2011 forecast p/e, meanwhile, is below seven. Even factoring in a small earnings drop in for next year, the p/e would still be under eight. That makes AstraZeneca a very cheap share indeed.

Category: Market updates