- You have an existing actively managed pharma sector PMS. Can you please explain the positioning of the fund?
We split the healthcare businesses into 5 buckets as follows:
- Companies focused on unbranded market exports of pharmaceuticals
- Companies focused on branded market for pharmaceuticals
- Contract research and manufacturing companies / API and chemical manufacturers
- Hospital chains and standalone hospital units
- Diagnostic chains
We believe that the runway for profitable growth is higher and more predictable for buckets “B”, “C”, “D” and “E” when compared to bucket “A”. However, when we look at the index, ~60% of the weight is indexed to companies that can be classified under bucket “A”.
Our experience suggests that investors reward consistency and growth in cash flows of companies. Hence, we believe that companies that exhibited lower volatility and better Return on Equity (RoE) over a period of time would be appreciated more by investors. As we can see in the chart above Healthcare Global (HCG)(“D”), Dr. Lal Pathlabs (Dr. Lal) (“E”), JB Chemicals (“B”) and Syngene (“C”) have delivered consistent cash flows over time and have been rewarded accordingly by shareholders. On the other hand, Sun Pharma (“A”) which is largely dependent on unbranded generics has seen high volatility in cash flows and the stock has underperformed.
For our Healthcare PMS, we primarily currently allocate 13% weight in bucket A (vs 42% in index), 33% in bucket B (vs 30% in Index), 33% in bucket C (vs 20% in index).
2. As part of the asset allocation for sector bets, should you go for actively managed PMS or Mutual funds?
In our view, the actively managed PMS like InCred Healthcare portfolio have a differentiated offering vs the mutual funds in the similar space. This is largely a function of having the agility to select the right companies to invest in, regardless of the market capitalization or available liquidity. Since, most of the large caps have unbranded generics dominated cash flows, the ability to invest in better quality cash flows is higher when the fund can invest in small and midcap healthcare companies.
3. What kind of companies do you select in your Pharma Fund?
We select companies based on our proprietary research framework. We evaluate each company on 5 quantitative and 5 qualitative criteria. We score companies on each of these criteria and then sum up the total score. Then we overlay the score with a valuation based criteria to select the companies that would be there in the portfolio. We also spend a lot of time debating and deciding on the weights of the stocks. More often than not, we end up buying companies with an honest and competent management and a sticky source of cash flow with higher than average return on invested capital.
- Return on Invested Capital (ROIC) versus Weighted average Cost of Capital (WACC)
- Quality of Capital Structure
- Cash Flow Adequacy
- Debt Covenants
- Earnings Growth
- Competitive Advantage (s)
- Pricing power
- Character of Management
- Alignment of Interest with minority shareholders
- Dependence of external variables
4. What are your house views on the Pharma Industry five years down the line, where is it headed?
While unbranded export markets have been and continue to be hard to predict, we have invested mostly in the domestic healthcare consumption story. FY10-FY20 data suggests that Indian pharmaceutical market grows at 1.6x GDP growth for the country (Source: AIOCD, World Bank). Barring hospitals, other segments of healthcare are by and large privatized and hence we expect the private sector in healthcare to exhibit double digit top line growth over the next few years
Government initiatives like Ayushman Bharat, PLI schemes and capital expenditure allocated for primary healthcare centres will also help improve the quantum and quality of growth of healthcare in India
5. The Pharma sector has clearly come out of a long bear market, and its mean reversion story seems to have already played out. What do you see as the key drivers going ahead – especially if you take a view that the worst of the pandemic is now behind us?
We slightly disagree with the premise of the question. The larger pharma companies that had and have high exposure to unbranded export markets like US saw an extra-ordinary high profitable growth in 2010-15.
This benefit was not accrued to many of those small and midcap pharma companies that are focussed on domestic and other unregulated markets. Since the US market is unbranded and there is low barrier to entry, and the high profitability of the existing large cap players in US in 2015 attracted multiple competitors. These competitors essentially destroyed prices in US to gain market share and that caused the mean reversion in profitability of the larger pharma companies between 2016-19
Although price erosion in select products in US remains elevated, on an overall market basis, price erosion has normalised to low single digits.
Key drivers for growth in unbranded generics would be new launches and niche products which give limited window of opportunity for players to gain high cash flows and margins. Hence, for the pharma companies that are US focused, temporary blips and increases in margins and cash flows will be a common phenomenon going ahead. We are relatively more optimistic on pharma companies that are focused on branded generic markets like India. We believe that the domestic market is more secular and growing more profitably vs unbranded export markets.
There is a common misperception that pharma companies benefitted from sales of CoVid related products. We believe that CoVid adversely impacted sales of acute products in the domestic market. Acute drugs are those drugs which are primarily prescribed to patients for a 1 to 5 day course. These ailments often happen when people are exposed to the environment outside their homes. Since in CoVid, most of the population stayed indoors for prolonged periods of time, the acute sales for pharma companies were adversely impacted.
Hence, we believe that domestic focused pharma companies and hospitals are more of a CoVid recovery play than a beneficiary of CoVid. Further, CoVid related sales were more significant for only a handful of companies that had a drug portfolio which was prescribed under CoVid. A significant portion of our holdings in InCred Healthcare PMS are those companies which had little to zero CoVid related sales. Hence, in our view, the best for most of our holdings lies ahead of us and the temporary disruption caused in their business due to CoVid is largely behind, unless we experience another severe wave of CoVid.
6. What will be the initial allocation across market caps when you cast your first portfolio?
We do not allocate capital based on the market cap of a company. We analyse business model and sustainability of cash flows. If the company passes the muster of our time-tested framework and valuations are reasonable, we allocate capital accordingly. However, as most of the large caps in Indian pharma companies are largely US focused businesses, we find ourselves largely allocating more capital to small and midcaps (which are more branded businesses) and less of large caps.
As of now, we have about 22% allocation to large caps (vs ~60% in the index) and balance in small and mid-caps.
7. For HNI investors, what makes more sense: core diversified PMS or sectorial based PMS?
In our view, a healthcare portfolio is also a diversified defensive portfolio and not sectoral per se. The business models of US focused pharma companies, India focused pharma companies, API manufacturers, CRAMS, hospitals and diagnostics are all unique and different variables impact these models differently. Hence, we believe as a consistent compounder, the InCred Healthcare PMS, should be a core holding in any client’s portfolio
8. What is your experience with HNI investors’ behaviour in your pharma PMS: do they come in only for tactical plays or are they willing to commit long term money?
Since the inception of our portfolio in Feb 2021, we haven’t seen any withdrawals and have seen regular top ups by existing clients. However, that is too short a time period to infer anything on investor behaviour. In my previous roles in managing a similar fund, I had seen investors generally being longer term investors as once they invest, they realise the benefits of the product in terms of consistent returns with low volatility.