A queasy feeling over big pharma

How adventurous is an investment in healthcare? Take pharmaceuticals companies, for example. Should they be regarded as mature cash cows that operate a little like utilities, or should they be trusted to use the excess capital thrown off to invest in new growth areas?

Institutions currently appear to be investing in them for the hefty yields on offer. UK giants such as AstraZeneca (yield 7 per cent) and Glaxosmithkline (5.3 per cent) get the headlines, but even the US groups such as J&J (3.6 per cent), Merck (4.2 per cent) and Pfizer (4.90 per cent) are paying quite generous dividends.

These pharmaceuticals giants are obviously having trouble finding replacements for their big drugs pipelines but their focus has switched inexorably towards cash flow generation and cutting back on low return-on-equity projects. So, the free cash flow yield in the industry is now well above 10 per cent, easily enough to pay yields of between 4 and 7 per cent a year.

However, there are distractions. Industry analysts love to show graphs of healthcare spending in emerging markets, implying that if only the big pharmas splurged on China, they could double their growth rates. Another possible drain on cash could be the biotech sector, where takeover speculation waxes and wanes daily, producing massive volatility.

This is the backdrop against which Polar Capital has launched its London-listed Global Healthcare Income and Growth trust (ticker symbol PCGH), targeting a blended pay-out of about 3 per cent a year in dividends. It is avowedly chasing the dividend cheques on offer within the broader healthcare sector, with an 80 per cent of its holdings in income- producing companies (mostly large cap) and 20 per cent in smaller growth stocks (with biotech well under 5 per cent).

But this fund faces the same challenge as those mature corporate cash cows: should it dump the glamour of growth stocks and focus exclusively on the dividend yield? Or will the managers be tempted to pick stocks for capital gains and see the overall yield slip to as little as 1 per cent over the next five to seven years?

Polar’s nearest equivalent – the London listed Finsbury Worldwide Pharmaceutical Trust – pays a yield of just over 1.3 per cent, having done a decent job of growing its capital 35 per cent in the past three years, during a period of sector-wide malaise. In spite of this, it has been trading at a discount to its net asset value of between 7 and 12 per cent. By contrast, Polar is already trading at a premium to its net assets.

So the cynic in me wonders whether Polar’s manager’s will be tempted to chase growth stocks and take on extra risk – simply to justify this big difference in the discount, compared with Finsbury. To be fair, the fund’s managers have been running an open-ended version of the Polar trust with some success in terms of income and growth for many years.

There are still a lot of risks, though. In the past three months, the global big pharma sector is down more than 10 per cent – in spite of its supposed safe haven status – with biotech down a lot more. But chasing glamorous growth stocks could still lead you into overpaying for growth – especially in the healthcare products and biotech sector, where the evidence suggests that technological innovation rarely translates into sustainable returns.

Investors looking for simpler ways to capture trends in global healthcare could consider iShares exchange traded funds tracking the S&P Global Healthcare Sector, the Dow Jones Pharmaceuticals Index and the DJ US Medical Devices index.

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