Significant upside for pharma stock prices, dividends

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. To give us an update on the Big Pharma space, I am here today with Damien Conover; he is our associate director of health care.

Damien, thanks for joining me.

Damien Conover: Thanks for having me, Jeremy.

Glaser: So toward the end of 2011 we saw a pretty big runup in some of the pharmaceutical companies' stock prices. I know we have thought that that space was undervalued for a long time. What does this mean for investors? Is the sector basically fully valued now?

Conover: Yeah, I think that's a great question. I think, the ramp in stock prices for big pharmaceutical firms is largely driven by improving sentiment for the industry. We expect that sentiment to continue to improve into 2012, and we still see the space as undervalued, not as much as we did last year, but still think there is some significant upside for a lot of the stock prices within the big pharmaceutical space on top of very strong dividend yields. So, I think, there's good chance for capital appreciation and strong dividend yields throughout 2012.

Glaser: So let's dive into this a little bit more. One of the big concerns that was weighing down sentiment was this patent cliff, in that a lot of big drugs for a lot of big companies were coming off patent and were going to face that generic competition. How are the firms responding to that threat?

Conover: Yeah, that's a great point. I think, when we look at 2012, this is the worst year for patent exposure for the big pharmaceutical firms. So, I think, really there was a huge degree of fear built up in the market as we approached 2012. However, firms are really adapting much better than I think most investors thought. They are adapting through improving their pipelines and doing major cost-cutting. So, despite what was perceived by the market as a major cliff and a major headache for the industry, the companies are adapting so well. I think that really drove a lot of the stock-price increases at the end of 2011. I think that sentiment continues to improve as pipelines improve and cost-cutting continues to materialize.

Glaser: Certainly in some ways those two--improving your pipeline and cutting costs--is a little bit contradictory. Is there any fear that they're cutting too much and that reduction in research and development spending will mean a less strong pipeline say five years down the line, when those drugs would be coming to market?

Conover: I think that's a good point. I think, when pharmaceutical firms do look at their cost structures, they have to balance the near-term gains versus the long-term growth rate. And this is particularly true for research and development, but I think what we're seeing is a shift in strategy in R&D, and that shift in strategy is really shifting toward unmet medical-needs areas. So, this is an area that could be like oncology or immunology, areas where there aren't a lot of drug treatments. So I think that strategy plays well into cost-cutting, as well, because typically the trials tend to be shorter in duration and need fewer patients. So, there is a little bit of overlap with cost-cutting and kind of a redeployment of strategic vision in R&D pipelines that should yield better pipelines and the ability to cut costs.

Glaser: These companies are truly global, and there's been a lot of worry about growth in Europe in particular, but also here in the United States. What kind of exposure do you think the Big Pharma companies have to further austerity measures in Europe or to a recession in Europe, and how are they handling that exposure?

Conover: Yeah. The geographic landscape for the pharmaceutical firms is really important because in different geographies you have kind of pluses and minuses going on. In Europe, as you mentioned, there are big austerity measures there; I think that continues at least into 2012, probably into 2013. So, Europe is not a real favorable market for big pharmaceutical firms. You kind of contrast that then with the emerging-markets area. These are areas where there is very strong population growth and wealth growth, and that really bounces off some of the headwinds that the pharmaceutical firms are seeing in Europe. So, if we look at the entire global footprint for pharmaceutical firms, I'd say it's relatively similar in 2012 as it was in 2011. However, different geographies have benefits being offset by the negatives in other geographies.

Glaser: Then you mentioned, you still see some values in this space. What are some of the companies that you're the most interested in now?

Conover: Yeah. One of our top picks is Abbott Laboratories. We really like its key product, HUMIRA. Abbott had a very strong 2011. We anticipate that strength in stock-price appreciation to continue into 2012, largely driven by HUMIRA, as well as some of the underappreciated businesses within Abbott, including the nutritional business, which has very strong barriers to entry and very strong wide-moat dynamics that really would bode well for some of the pieces here for Abbott that I think just are overlooked. And Abbott is looking to split itself into two pieces. So, I think, investors may look at some of the underappreciated assets within Abbott more carefully, hence potentially more stock-price appreciation.

Glaser: Are there any other firms that you are interested in now?

Conover: Yeah. Another firm that we would point to is Pfizer. Pfizer is, I think, a great example of cost-cutting. It has done a tremendous amount of cost-cutting in 2011, will likely continue to do that into 2012, and its strategic redeployment of its pipeline looking at these unmet medical needs is doing very, very well. I think, Pfizer has probably the best pipeline it's had in the last five years. It's a very strong pipeline; cost-cutting really bodes well for Pfizer as we look into 2012.

Glaser: Well, Damien, as always we appreciate your insight. Thanks for being here today.

Conover: Thanks for having me, Jeremy.

Glaser: From Morningstar, I'm Jeremy Glaser.