The pharmaceutical sector is a clear value, especially when compared to valuations on the remainder of the S&P 500. The sector trades at a 40% discount to the S&P 500. On a free cash flow basis the gap is even wider. However, pharma has been a value trap for many years now and more than a few people got nicked trying to call the bottom in the group.
The reason I chose to go into the group was that I saw a catalyst that would unlock the value. A few major mergers were announced in the group where the combined cash component was over $60 billion. That means that well over 5% of the outstanding stock in the sector will be retired. Yesterday, Pfizer closed its merger with Wyeth which had a $40+ billion cash component. A lot of that cash was subsequently reinvested in other pharmaceutical companies and the pharmaceutical sector has had a nice run.
However, now that my major catalyst is in the rear view, what will further close the value gap? Merck and Schering Plough will merge in the near future which will bring some more cash into the sector. However, the cash component of that deal is much smaller than that of the Pfizer deal and more will be required.
The majority of heavy lifting will need to come from investors returning to the sector. After a decade of losses investors have grown weary of the pharmaceutical sector. However, as we saw with the financial stocks, investors are very quick to forgive once prices start rising. Once the sector starts moving, managers who are underweight the group will need to get back in to keep up with the indices. I believe that process has begun. But if I am wrong the low P/Es and high dividends should protect me while I am waiting.