Pharmaceuticals were long considered to be a core portfolio holding. Sector shares rewarded its fans throughout the 1990s by rising steadily on the strength of increasing sales, earnings and dividends.
But the sector disappointed investors in the last four years. Prices turned down suddenly and savagely in November 2000 in lockstep with the rest of the stock market. The new stock market advance that began in March 2003 brought little relief to Pharma shares. The sector advanced by just 20 per cent since then. To put this figure into context, the FTSE-All Shares index advanced 55 per cent in the same period.
Sector prices have been hit by a number of well-publicised problems. They include patent expiries, disappointing earnings, excessive executive compensation, high new drug development costs and important safety issues. They have been generating front page news for several years. The poor news flow continues right to the present.
Some analysts believe Pharmaceuticals remain a sector to avoid, not embrace. Others believe all the bad news is out in the open and the next big move is up, not down.
In the face of this uncertainty, here are some tools to help you to analyse sector prospects in the future.
Fundamentals
As experienced investors are well aware, price/earnings ratios are computed by dividing the price of a share by the earnings attributed to that share. A share selling for 100 pence and earning 10 pence per share would have a p/e ratio of 10.
At Pharma's price peak in November 2000, its price/earnings ratio was a whopping 45, double the level for the stock market as a whole. This attested to the premium that investors were willing to pay for a share in this sector. But the current level is just 18, close to broad stock market levels. In other words, the sector has lost virtually all of its premium rating in the last four years.
It is also worth noting that the price/earnings ratio has stabilised. Our graph illustrates that a baseline has been in place for the last two years in the area of 16. The p/e ratio even maintained this level in the last six months despite a series of horrid sector-wide news reports from both sides of the Atlantic.
Viewed from this perspective, the p/e chart hints of little downside share price pressure unless there is a sector-wide earnings collapse.
Happily, analysts who closely follow the sector do not consider an earnings collapse to be a likely event. There is healthy debate about the potential for earnings increases, but widespread belief that earnings will not get worse (on a sector-wide basis). Putting it all together, there is appears to be little downside risk to sector share prices.
Little downside risk is an important issue of course, but not a sufficient reason to invest. We must also see signs of share price growth. Will the Pharmaceutical sector satisfy investors in this regard? Here are two indicators to help investors answer this question.
Technical analysis
The 200-day moving average trend line is a useful diagnostic tool in this sector. Our second chart illustrates that the line serves as an important support area. During past periods of strength, prices often fell to the area of the line and reversed direction.
The reverse was also true. When shares were low in price, rallies often ran out of steam once they approached the 200-day line and reversed direction.
Best of all, occasional decisive penetrations of the line have been an important sign in the past. Such penetrations were often followed by solid multi-month continuation moves.
It is not a foolproof predictor of course. No indicator works 100 per cent of the time. Even so, it is an indicator worth monitoring.
Sector prices are currently about one per cent below the 200-day line. If the past is any guide, a decisive penetration above this line could lead to further advances. On the other hand, an inability to make a decisive breakout is a signal for investors to stand aside.
Chart number three shows the sector's price trend since 1995. Notice the blue support/resistance line that has run for the last six years. It served as a barrier against further gains in 1997-98. Once decisively penetrated, it opened the door to a series of substantial follow-up rallies.
And more recently in July 2002, the line was penetrated to the down-side. Here too, the penetration was followed by a substantial follow-up weakness.
There have been a half a dozen failed attempts to rise above this line in recent years. Each rally quickly fizzled.
Pharmaceutical sector prices currently sit about 12 per cent below this line. Investors should treat long-term sector prospects with considerable caution unless prices decisively rise above the resistance line on Chart Three.
The Bottom Line.
The worst is probably over for Pharmaceuticals. But, so far, there is no strong evidence that the sector is in rally mode. For short-term traders, the best strategy to follow is to treat any breakout above the 200-day moving average as a short-term trading opportunity. Longer-term investors would do well to remain on the sidelines until the blue resistance line of Chart Three is penetrated.