To The Moon

$Pfizer(PFE)$ $Biogen(BIIB)$ $Novo-Nordisk A/S(NVO)$ $Johnson & Johnson(JNJ)$

Pharmaceutical companies is a favorite among the dividend investment community. During the pandemic, the company often reminded us that we were heroes. Meanwhile, on social media, people were labeling Pharmaceutical as "evil" due to conspiracy theories about vaccine containing microchips. What a time to be alive!

In this article, I’ll explain why not to invest in pharmaceutical companies. But before diving in, let’s consider what the most renowned investors tend to look for in their portfolios.

Legendary investors favor companies with competitive advantages, reliable operations, predictable finances, and undervalued stock at the time of purchase. One key element in their strategy is the risk-to-reward ratio. If this ratio is favorable, the investment becomes more appealing. However, every industry carries its own risks, some more than others.

With that in mind, I argue that pharmaceuticals carry significant risk, and here’s why:

Reason 1: Regulatory Risk

The pharmaceutical industry operates under the strict control of regulatory bodies like the FDA. Even if you have a product ready to launch, complete with a rollout plan and factories prepared for mass production, approval is never guaranteed. Every day a drug's release is delayed costs the company money, and unexpected outcomes or side effects could later lead to lawsuits or litigation. While initial profits might be high, companies often face long-term financial consequences from settlements and other liabilities.

Reason 2: Uncertainty in R&D

The research and development (R&D) pipeline is fraught with uncertainty. Consider a drug pipeline like Merck’s: it starts with hundreds of candidates in Phase 1 but narrows dramatically by Phase 3, with fewer than 5-6% of drugs making it to market. Developing a drug can take 10, 20, or even 30 years, and the odds of success are slim. Imagine running a business where 95% of your investments yield no return—that’s the pharmaceutical industry in a nutshell.

Reason 3: Patent Expirations

Pharma companies rely heavily on exclusive patents for their profitability. Once a patent expires, revenues can plummet as generic competitors flood the market. For example, when Pfizer’s cholesterol drug Lipitor lost its patent, its revenue dropped from $9.5 billion to $3.9 billion in a single year. The reliance on a small number of blockbuster drugs makes these companies especially vulnerable.

Reason 4: Pricing Controversies

Drug pricing is a contentious issue globally, but especially in the United States. The same drug that costs a fortune in the U.S. is often sold at a fraction of the price in other countries like Canada or Turkey. Pharma companies justify this by leveraging their pricing power in regional markets, but the backlash is growing. Legislative changes aimed at making drugs more affordable could drastically impact the industry's profitability.

Remember the example with Pfizer and their cholesterol drug? I genuinely believe this kind of situation is bound to happen again—and sooner rather than later.

Reason #5: The Valuation Process Is Too Vague

As a value investor and dividend enthusiast, I prefer to calculate a company's worth before buying its stock. That way, I can determine if there’s a margin of safety and whether I’m getting a good deal. However, with pharmaceutical companies, the valuation process is far from straightforward. Their heavy reliance on drug pipelines introduces significant uncertainty, making it nearly impossible to arrive at a precise intrinsic valuation.

There are additional complexities, too: the success rate of new drugs, the ever-present litigation risks, the impact of political decisions, and the dependency on attracting new patients. All of these factors make forecasting future cash flows for pharma companies more guesswork than science. If you can’t calculate a fair price for a company, how can you determine if it’s undervalued? A 20%, 30%, or even 40% drop in stock price over the past few years doesn’t automatically make a company undervalued. More often, it signals issues like a lack of promising R&D pipelines or expired patents—problems Wall Street has already priced in.

Pharma Down Trend

In 2024, the pharmaceutical sector faced notable challenges, leading to a general downtrend in stock performance. Several key factors contributed to this decline:

Regulatory and Political Pressures: The re-election of President Donald Trump introduced uncertainties, particularly with the appointment of Robert F. Kennedy Jr. as head of the Department of Health and Human Services. Kennedy's critical stance on traditional healthcare services, including pharmaceutical companies, raised concerns about potential policy shifts that could impact the industry's profitability.

Market Dynamics: While the S&P 500 achieved significant gains, the healthcare sector, including pharmaceuticals, underperformed. From September 16 to December 12, 2024, healthcare stocks in the S&P 500 dropped nearly 10%, reflecting investor apprehension about the sector's future prospects.

Competitive Pressures in Specific Drug Markets: The weight-loss drug market, for instance, saw intense competition between companies like Eli Lilly and Novo Nordisk. Eli Lilly's stock rose by 33% over the year, while Novo Nordisk's shares declined by 28%, indicating market volatility and the high stakes involved in pharmaceutical innovation.

Investor Sentiment and Defensive Strategies

Given the uncertainties, investors began favoring more defensive sectors. Despite their underperformance in 2024, sectors like healthcare and consumer staples are considered undervalued, trading below their five-year highs and at a discount compared to the S&P 500. This shift in investor sentiment further pressured pharmaceutical stocks.

Simplicity Is Key

By contrast, some industries offer business models that are straightforward and easy to evaluate. Take Realty Income, for instance. They own properties, and businesses pay them rent to operate on those properties. Simple, right? Full disclosure: I’m an investor in Realty Income, and it’s a model so intuitive that you could understand it like 1+1=2. Speaking of which, I recently made a article discussing why I think Realty Income is undervalued right now. If you’re tempted by risky stocks, let me save you the trouble: skip them and consider something more reliable.

Pharmaceutical companies might seem enticing when their valuation metrics look appealing, but I avoid investing in them. Despite my experience in the industry and my respect for their critical societal contributions, the regulatory challenges, patent expirations, complex business models, and uncertain pipelines make the sector too unpredictable for my liking.

The Bigger Picture

When it comes to investing, we should apply the same high standards we use for other major life decisions—whether it's choosing a car, a house, or even a spouse. If a company has an unpredictable cash flow model, why would you buy into it? This isn’t to offend those who favor pharma stocks. I’m simply sharing my perspective based on my experience and opinions. The good news is, there are plenty of other sectors and industries to explore in the stock market. No one is forcing you to invest in Big Pharma.

For example, I also steer clear of airline companies, car manufacturers, and even the publicly traded stock of Manchester United—a team whose performance often leaves much to be desired. They’re entertaining to watch, but they’re not on my investment radar.

Conclusion

Final Thoughts Even though I avoid pharmaceutical stocks, I acknowledge their importance to society. They’ve eradicated diseases, improved countless lives, and made profound contributions to healthcare. That said, we need to evaluate companies objectively—looking beyond stock prices to assess their finances, fundamentals, intangibles, and growth potential. Let’s not allow emotions or biases to cloud our judgment, whether in the stock market or life.

In summary, the risks—regulatory hurdles, R&D uncertainties, patent vulnerabilities, and pricing controversies—are too significant for me to justify investing in Big Pharma. While these companies can generate impressive short-term profits, the long-term risks are substantial.

What do you think?

@Daily_Discussion @TigerPM @TigerObserver @Tiger_comments @TigerClub