Read Part-1 here: The Building Blocks of Pharma Sector
Read Part-2 here: The Regulatory Framework in the Pharma Sector
During this 5-weeks course series, we target to capture the following modules:
Moving on with Module-3 of this course, this blog intends to present you a financial overview of the sector.
We shall also be using the Magic Formula of Joel Greenblatt to analyze the pharma stocks in the pharma sector.
Let us first have a financial overview first:
Pharma Sector: Financial Overview
Pharmaceuticals is a huge industry with hundreds of listed pharma stocks. So for the ease of analysis, we have picked the Top 10 Pharma stocks by Market Capitalisation as the universe for presenting this financial analysis.
Also, these 10 Stocks constitute the Nifty Pharma Index.
|Stock||Market Cap (Rs cr)|
|Dr. Reddys Labs||77,671|
Let us look at companies by highest Sales. The list is as below:
|Stock||Sales (Rs cr)|
|Dr. Reddys Labs||18,183|
Price/Sales or Market Cap/Sales
If we tally the 2 above-mentioned tables then we can calculate Market Capitalisation/Sales for all these top 10 pharma stocks.
Price/Sales or Market Cap/Sales shows how much investors are willing to pay per Rupee of sales for a stock.
The key finding here is: Divi’s Lab and Biocon share moves higher/faster for incremental sales than other large-cap pharma majors.
We consider ROCE as a paramount ratio for analyzing the capital efficiency of the pharma stocks. So, we have calculated the ROCE for all 10 stocks and the result is below:
|Stock||ROCE ( %)|
|Dr Reddys Labs||11.1%|
Companies with a large share of EBITDA from India (e.g. ALKEM) have reported better ROCE against export-oriented companies (e.g. Aurobindo, Sun, DRL) during the last 5 years
What Does EBITDA Margin Tell Us About Pharma Stocks?
EBITDA Margin tells us a lot about the business model of these Pharma companies below:
DIVI’S Lab score high with 40% EBITDA Margin as it earns 41% Revenue from custom synthesis business where it enjoys strong relationships with big pharma
Mr. Joel Greenblatt a legendary Investor had written a small book (76 pages if I am not wrong) named “The Little Book That Beats the Market” and had propagated the idea /framework he calls “Magic Formula Investing”.
The performance of this portfolio has been stellar as shown below:
What is Magic Formula?
Magic Formula Framework in 5-easy Steps
We have broken down this framework into 5 easy steps:
First, we define the universe: As we have seen that by market cap, all top 10 companies are formulation companies, so we have expanded the universe by adding Top 10 API manufacturers in the list so that we get a balanced view and representation.
Here goes our list:
Step 1: Calculate ROCE
Step 2: Rank High ROCE Cos
Rank the Pharma Stocks (or any other set of stocks) with the highest ROCE as 1 and others similarly. So the list looks like this:
Step 3: Calculate the Earning Yield
Step 4: Rank basis high Earning Yield
Rank the stocks with the highest Earning Yield as 1 and others similarly. High Earning Yield means that the company is undervalued
Step 5: RankSum i.e. Best of both world
Add both the Ranks and Arrange the stocks in increasing Rank Sum order as below:
What is the End Game?
So the endgame is finding 2 winners and sell 2 losers.
If it is in your portfolio, calibrate the portfolio after 1 year by repeating all 5 steps again. Period. The Magic Formula can be applied to any set of stocks.