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#Investments — 25.10.2018

Change In Sector Recommendation: We Upgrade The Pharmaceutical Industry

Guillaume Duchesne

Equities are currently under pressure given the fears over global growth and the political risks in Europe.

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Amid this challenging environment, the stock market correction has been drastic, and all sectors are down, including the most defensive ones, since the peak reached by the MSCI World index in September.

However, we do not believe that this is the end of the cycle. We continue to like equities at this stage. In particular, we see a significant gap between good fundamentals (solid company earnings) and attractive valuations. We therefore stick to our positive view on pro-cyclical sectors (Materials, Industrials), Financials and an atypical sector: Energy. 

Moreover, we believe that the recent downward trend is a good opportunity to rebalance our sector recommendations in favour of the pharmaceutical industry (in the US and Europe). We upgrade this industry from neutral to positive. Its strengths are: 

  • Strong earnings growth. The relative earnings momentum has recently stabilised in the US. In Europe, EPS (earnings per share) has been revised upwards (after a long period of negative revisions). Profit margins are solid. Sales forecasts in the industry are decent (5% in Europe, 4% in the United States), driven by a new products cycle, particularly in Europe.
  • A less negative sentiment on the industry since the summer. Market events have brought the sector back onto investors' radar screens. On the one hand, the pharmaceutical sector seems to be immune from trade pressures and is less sensitive to macroeconomic uncertainties. On the other hand, investors had long snubbed the sector, because of concerns about pressure on US drug prices caused by the Trump administration.  The regulation in the industry remains uncertain, particularly in the run-up to the mid-term elections. The US administration continues to put pressure on drug prices while President Trump, bent on addressing this issue, may reopen the debate at any time. Meanwhile, pharmaceutical companies have offset this impact by controlling costs and have reassured that the price change was manageable. Investors have identified the risk by putting their price concerns on the back burner.
  • Fair valuations. While Industrials are close to their two-year average in the US (15.4x), the price-to-earnings ratio is attractive in Europe at 14.6x.
  • Defensive nature. Against a difficult market backdrop, the pharmaceutical industry is benefiting from its defensive nature while offering strong earnings growth. This combination may be particularly attractive for investors wishing to rebalance their portfolios in the context of market uncertainties.

Nonetheless, we remain selective within defensive sectors. Based on our scenario of robust economic growth, a gradual hike in interest rates and, ultimately, a rebound in the stock markets, we remain cautious on most other defensive sectors that are the big winners of present market concerns: Consumer Staples (negative view), Utilities (negative view), Listed Real Estate (neutral view) and Telecoms (neutral view). The telecommunication services sector has benefited from a sudden burst of interest among investors, who are attracted by the high dividends and the domestic nature of the sector (i.e. less sensitive to trade tensions and concerns over global growth). The telecommunications sector in Europe, however, is suffering from weak revenues and price pressure in a still fierce competitive environment. That said, many of these risks are well known to investors and appear to be priced into current valuations. Nevertheless, we prefer to remain neutral at this stage.