Identifying Select Opportunities in Branded Biopharmaceuticals

While the broader biopharmaceutical industry is not necessarily inexpensive, we believe there are significant value opportunities on an individual stock basis. Generally, demand for pharmaceutical drugs arises from medical necessity, driven by demographic trends such as an aging population and the growing wealth effect (healthcare consumption/spending correlates highly with per-capita GDP growth). Drugs account for a small portion of overall healthcare spending, representing 11% of the U.S. healthcare budget according to the Centers for Medicare & Medicaid Services, and 14% of the E.U. healthcare budget according to the Organisation for Economic Co-operation and Development. These drugs contribute to keeping overall healthcare costs down. Simply put, we believe our pharmaceutical holdings are among the most inexpensive drug companies globally.

Overall, the risks can be categorized into macro (such as affordability) and micro (including innovation, patent expiries, and cash usage). Concerning U.S. drug pricing reform, while discussions on drug pricing are expected during this election cycle, it's largely factored into the market due to well-documented policies led by Biden (such as Medicare direct negotiation in 2026, specific to drugs). However, the potential outcome under a Trump administration should also be considered. Generally, Republicans are perceived to be more supportive of the pharmaceutical industry. Additionally, significant changes to drug pricing require approval from all three levels of the U.S. government, limiting unilateral actions. Our perspective on branded drug pricing is that market forces will continue to play a dominant role in exerting price pressure, particularly in competitive drug categories. Therefore, we tend to favour innovative businesses that are resilient to competitive pressures, as well as companies with products enjoying limited competition or clear advantages over existing therapies. Nonetheless, we remain mindful of the earnings cycle of each company.

According to Visible Alpha Consensus, the United States remains a key player in the pharmaceutical market, with spending on branded prescription drugs expected to continue growing at approximately 7% annually until 2030 (about 5% excluding pipeline investments). We hold a positive macro-outlook for the pharmaceutical industry, given its inherent defensiveness, non-cyclical nature, low leverage, and typically strong cash generation. In addition, the concurrent increase in employment rates should also drive drug utilization. Industry insiders maintain that there is significant opportunity to develop new medicines that address unmet needs. In other words, the most effective strategy for navigating a challenging pricing environment is to discover new products that provide clear value and are deemed worthy of investment.

Pipelines are influenced by advances in medical knowledge, with companies vying to be the first to exploit innovative approaches to various diseases. This often results in waves of new products emerging concurrently, as firms strive to capitalize on medical breakthroughs within similar timeframes. The resurgence of research and development (R&D) productivity represents a sustainable development for the industry, and innovation remains, in our opinion, one of the best methods to sustain positive returns. Our portfolio companies boast pipelines filled with innovative treatments across areas such as oncology, gene therapy, and Alzheimer’s disease. While this may not currently be the market's primary focus (due to mixed results in the stocks we own), it remains a potential source of upside.

Valuation

Currently, there's a clear divide between "obesity" and "non-obesity" stocks. We find the valuations of "non-obesity" pharmaceutical companies particularly appealing, especially in those cases where valuations have dropped to levels last seen in 2010, during a time of similar concerns. Back then, as now, portfolios didn't require high-risk "execution stories" or "show me" stocks to outperform the market. We would argue that while we take on execution risk, outside of an extreme outcome, there are still abundant free cash, innovation and restructuring opportunities to offset any top-line pressures. This is not reflected in the stocks we own.

We categorize the value within our holdings into two groups. Firstly, there are the pharmaceutical companies that we believe are relatively undervalued (ie: Biogen, Gilead, GSK, Roche, Sanofi), which are heavily discounted due to specific issues related to their products or management. Despite these challenges, it is our opinion that these companies offer notable upside potential based on their marketed drugs and R&D optionality on offer (drugs in development). On the other hand, some stocks are not as 'cheap.' These stocks generally have more stable cash flows, decent growth, and good capital stewardship. The potential upside for these stocks comes from their pipeline optionality and effective use of cash (ie: Abbvie, and Novartis - both stocks have seen a re-rating since we bought them at depressed valuation levels). In summary, our holdings consist of businesses that do not currently reflect much value for their current portfolio of marketed drugs and give little value to their pipeline success.

Below are two examples of our U.S. pharmaceutical holdings:

• AbbVie - has an innovative and sustainable business. The company is working through a well-known patent cliff in Humira, but the revenue shortfall should be offset by 1) the launch of two next-generation immunology products, 2) stable revenues in oncology with pipeline optionality, and 3) The recently acquired Allergan brand adds durable growth franchises in neuroscience and self-pay aesthetics (Botox). Put simply, excluding Humira, AbbVie should have a more diversified and growing business with leadership positions in attractive therapeutic categories. As the market gains confidence in earnings resilience, AbbVie’s valuation discount should narrow. In the interim, cash flow generation remains relatively strong, supporting a well-covered and growing dividend (currently a 3%+ yield).
• Gilead Sciences - has a portfolio of growing products and optionality tied to pipeline success. With a relatively solid capital structure and a share price that doesn't yet reflect the upside from pipeline progression and/or growth from currently marketed products (particularly in HIV treatment), we feel Gilead offers a favourable medium-term outlook. Multiple valuation inflection points and effective management execution over the coming years should further reduce the risk associated with the value thesis and unlock embedded value. Meanwhile, relatively strong cash flow generation supports a well-covered and growing dividend (currently a 4%+ yield).

In our opinion, the long-term demand fundamentals for pharmaceutical drugs remain solid despite headline risks on a macro scale, such as U.S. elections, and company-specific idiosyncratic factors like major drug patent expires. Pharmaceutical stocks can provide an attractive means to fortify portfolios, as they currently trade at relatively inexpensive valuations compared to other sectors. These stocks typically exhibit robust secular demand drivers, innovative pipelines, healthy balance sheets, and often offer investors attractive, well-supported dividend yields.