By Conrad de Aenlle / Reuters
June 12, 2014

Drugmakers have become fond of one another.

Merger activity in the industry was 21% greater, in dollar terms, at the start of this year versus the fourth quarter of last year, reaching $44.9 billion, according to PricewaterhouseCoopers.

The wheeling and dealing has helped draw in investors, judging by the double-digit gains this year in many drug stocks. But it is also stirring caution among fund managers with heavy exposure to the industry.

Don’t get sidetracked by the prospect of further mergers, money managers say. Instead, focus on the basics: valuations, earnings growth and dividends.

One takeover bid that caused much consternation in the sector didn’t even go through—AstraZeneca ASTRAZENECA PLC


said “no thanks” to Pfizer PFIZER INC.


. The episode caused Eric Sappenfield, co-manager of the John Hancock Global Shareholder Yield Fund, to turn cautious on Pfizer, although he still owns some shares.

“The bid for AstraZeneca was a 180-degree turn,” says Sappenfield, whose fund is a top performer over three and five years among world equity funds, according to Lipper, a unit of Thomson Reuters. He added that “the jury is out on what management is trying to do at Pfizer.”

Pfizer is the largest holding in T. Rowe Price Institutional Global Value Equity Fund, which ranks in the top quintile in returns over the last year among world equity funds, according to Lipper. “They’re very well managed, they’re great at generating cash from their existing franchise, and they’re skilled at deals,” despite the failed attempt to woo AstraZeneca, says the fund’s manager Sebastien Mallet. He likes Pfizer’s price/earnings ratio of 13, based on 2014 earnings, plus its 3.5% dividend yield.

Three of the other top 10 holdings in the T. Rowe Price fund are large drugmakers, too. Overall, healthcare represents 16% of the portfolio. (The fund has a total expense ratio of 0.75%.)

“After strong growth in the 1990s, the drug industry “became complacent, with unfocused (research & development) and very little to show in their pipelines,” Mallet says. “The stocks were cheap and controversial, so I bought a lot of them.” In recent years, he contends, drug companies have become more efficient businesses, and their research efforts are improving.

One of his holdings, Novartis NOVARTIS AG


of Switzerland, swapped some of its assets in April for others belonging to GlaxoSmithKline GLAXOSMITHKLINE PLC


. Mallet expects the move, sort of a merger-lite, to allow the companies to play to their strengths — cancer treatments in Novartis’s case.

A big draw of another holding, Teva Pharmaceutical Industries TEVA PHARMACEUTICALS INDUSTRIES LTD.


, is its cheap P/E ratio of 11, based 2014 earnings. Concerns about the imminent expiration of patents on its leading drug, Copaxone, a multiple sclerosis treatment, are “overblown” because the Israeli company is developing easier, less expensive, less painful methods of administering Copaxone that he expects to limit the appeal of generic versions.

Mallet describes another portfolio holding, Johnson & Johnson JOHNSON & JOHNSON


, as “a sleepy company with fantastic assets that became more focused and started to have a better pipeline on the pharma side.” At a P/E of about 16, its valuation is in line with the broad market, but “it’s a very high-quality company, solid as a rock,” he says.

Sappenfield is less interested in value than growth, which he considers vital to a company’s ability to pay and increase its dividend. He has a modest stake in Johnson & Johnson, which he admires for having “an abnormally high growth rate for the kind of battleship company they are.”

Sappenfield prefers other drug stocks, though, including Novartis, Glaxo and two others in Europe, Sanofi SANOFI S.A.


of France and its Swiss counterpart Roche Holding


. He favors them not just for their ability to grow but to do it reliably.

“Pharma companies generate a reasonably predictable stream of profits,” Sappenfield says. “You want to see that consistency. That’s why we’re in the big guys. They’re marketing machines with sustainable pipelines.”

His fund has about a 9% stake in healthcare stocks — less than average — but he rates drug stocks highly while shunning other segments of the healthcare group, such as medical equipment providers and hospital operators. The John Hancock fund has a total expense ratio of 1.34%, according to Lipper.

Sappenfield isn’t too worried about paying the right price for stocks, but he hates to pay the wrong price. He sold Bristol-Myers Squibb BRISTOL-MYERS SQUIBB CO.


because it got too expensive, he says. “Expectations for some of their drugs were so outrageous that everything had to be perfect for Bristol-Myers to work.”

Mallet expresses some valuation concerns of his own. Although his exposure to drugmakers remains high, it has come down slightly as price-earnings ratios have increased, and he expects to cut back further if the trend continues. But he still finds far more working for them than against them.

“They have refocused their business models and cut costs,” he says. “The stocks are less cheap, but they still have good cash-flow generation and dividend payments.”

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