The Mutual Fund Show: Are Pharma And I.T. Funds Still Good Investment Options?

I think healthcare is sort of an interesting sector. If you look at healthcare in the India context, for a few years healthcare or pharma was dealing with its own set of issues, whether it was U.S. FDA approvals or whether it was pricing issues in the U.S. I think life has come back into the sector and well before we launched a pharma fund this year on your own, we started going overweight on healthcare as a segment. I think with Covid-19 that has happened and it’s not about the vaccine; it’s about the fact that healthcare as a sector—whether it’s in India or globally has gone up and healthcare spending is due to increase across the globe. So Covid has been a driver but healthcare spending is due to increase around the globe. In fact, I think we think that the Indian healthcare sector will probably grow at 20-25%, just because of the increasing healthcare spends and there are a number of things that you can benefit from in healthcare. So, healthcare has a lot of impetuses—whether it’s government and private spending going up, whether it’s India which has been the pharmacy for the world sort of moving up the value chain, whether it is the API story so we can talk about all of these in detail, but now there are, I think, multiple drivers for healthcare as a sector. I think it’s also a sector where one of the questions that comes up that has been beaten down for the last four or five years. So, from a valuation point of view while healthcare funds have seen some pickup and returns, I think the long-term trend is just starting in healthcare.

We actually turned positive on the healthcare sector about a year back and there were a couple of reasons for that. One is, obviously the domestic story always looks good and it’s been a steady compounder, growing at around 12% or so. And there are various initiatives which drives investing growth over there—the insurance sector picking up and also the Indian companies are getting a lot of investment into the domestic market to try to grow that market. That’s always the case. The challenge was on the export front- U.S., which was a large generic space has seen a lot of pricing erosion. And we had seen the large pharma companies have under-performed for the last five years because in 2015 to 2019, there was a big under-performance and that’s when we thought, okay, fine a lot of it is there in the price evaluations that have been corrected.

So, slowly you will see that on the U.S. front the pricing pressure which had seen almost 10 to 15% price erosion for the last 50 years, was kind of a beating and the price declines were coming down to 4-5%, and many Indian companies which had invested large amount of amount of money in R&D, the extent of around 8-10%, in the last five-six years, a lot of those products were coming to the market; be it specialty chemicals or pharma products or in bio pharma. So those products were coming to the market and that will drive growth. As a result, we can positively launch a pharma fund also, but as you progress during the year we’ve seen that the story of pharma has actually turned out to be much better, more so on the international front. Now because of the pandemic we’ve seen that a lot of Indian pharma companies in the past had suffered because the U.S. FDA was very strict and many companies had received warning letters or their plants were to be shut down, but slowly we’re seeing that pressure was easing off. The U.S. FDA was becoming more lenient in terms of granting permissions. So that helped and also the competent density in the U.S. generic space also gone down because there was a lot of consolidation that didn’t happen because of the pricing pressure. All the generic players went out of a few products and that has benefited the pricing environment. Finally, because of Covid, we have seen an uptick especially for a few categories of products.Also, I think China has another role to play. China was a large supplier, not only for APIs but also for formulations and with the Covid and the China trade war; we’ve seen that a lot of companies are referring to some of the sources of the API from the Indian companies. That’s the reason why we saw in the last two quarters-the API story which had kind of died down in India for many years now, has resurfaced. That’s provided another leg of opportunity over there.

So, I would say that the sector now has done well; the evaluations are longer as attractive as what they were a year ago. So, the P/E multiple or the price to book value multiples- the valuations look fair at this point in time. But I think the overall domestic pharma story will continue to compound, we don’t see any problems over there. I think even in the U.S. export front too, you should see a more steady growth going forward. As Radhika mentioned, there are other aspects for Pharma. So, our fund is not only Pharma but Pharma healthcare and specialty chemicals. You’ve seen that all these sectors actually provide a good long-term growth opportunity. Even the healthcare space, it is just the beginning. In the hospital sector, if you look at it there’s still a huge amount of under penetration. India requires a large number of hospital beds and that’s a story where I think you’ll see tremendous growth going forward. Also the diagnostic space is growing pretty good. A shift from the unorganised to organised sector is yet to happen over there. With Covid, I think testing will only increase. So, that’s another sector as well as wellness in general I think there is a lot of focus. So, I think these are all more long-term and sustainable themes. I would say that investors even now should see a feasible performance, not such a great performance what we saw in the last one year but I think the sector still looks to deliver steady returns in the coming years.

Pharma will largely, I think play out this year, but otherwise it will be a more stock specific story. Individual companies depending on their product pipeline, what kind of new approvals they have for products, especially for the U.S. market I would say; I think that will drive the performance over there. There are quite a few companies like VC- we think will compound at around 15% in the sweet spot, which you will look at and the domestic pharma sector is growing at around 10-11%. And within that people or companies who are on the economic side, they are likely to see a much better growth. So I think that space will also probably grow. So, I think one can expect least the better companies in this space which have got a stronger pipeline to see that kind of an earnings compounding over the next two to three years time.

Absolutely. So we are coming with I think the first passive product in the space that is an indoor global healthcare fund. I think just to continue with what Mahesh said, when we look at pharma we actually don’t look at this as a pharma fund, we think of it as healthcare as a broad theme which is why the name is healthcare. That has four segments Pharma being one, diagnostics being the second because that will pick up, hospitals being the third and then medical equipment and tools being the fourth. Now while there is a tremendous story around Indian Pharma which Mahesh already alluded to, pharma is also as an incomplete story in our opinion without global pharma. I think this is interestingly true of technology as well. If you look at healthcare, the leading innovation and research that happens in healthcare is actually in the U.S. So, the U.S. probably today has about 40% share in the global Pharma market. It must be 5% of the world’s population. In terms of their spending on R&D in pharma, they are on the top of the charts and also the U.S. companies in terms of patent counts are at the top of the charts. So we think pharma is a two-part story. It’s benefiting from the innovative work in biotechnology and research from the U.S. and also some European countries, etc. So, there are a fair number of counterparts in Europe and the consumption story that’s playing out in pharma which is why when we are coming out with a fund, we’re trying to make it a package that covers 45 companies from India and across the world.

The technology space has gone through a lot and India specifically has gone through some transformation. 10-15 years ago, we were just doing the basic application and development because of the mainstay outsourcing. Over a period of time, we’ve seen that Indian companies have tried to go up in this space; especially on digital because they realised a lot money was moving towards digital. Now five to six years back we saw top Indian pharma companies trying to wary up their overall revenues coming in from digital. And that has now reached a healthy proportion. It’s nearly 13% for some of the top companies. That I think makes Indian companies well positioned to really capture the spend in the IT space, which now especially because of the transformation towards both digital and to cloud adoption- these are the two themes which we’re playing out.

Covid has only accelerated that spend in those areas and recently there was a survey done about the top companies in the U.S., and they are talking about impeding spend on digital transformation trying to see that digital cut not only at the front end but also the back end and that is where the spend is going to increase. I think the Indian companies are now at least well poised to capture that spend. Obviously with Covid, what has happened is that with the focus on outsourcing- many companies are trying to cut their costs so all the companies who had gone for in house. From outsourcing there was some trend towards in house IT spend. That is again likely to change and we’ve seen that outsourcing is likely to increase and that’s what the recent trends have shown in terms of new orders. So, on that space too, India is very competitive and has got a huge pipeline and resources to cater that demand. So, in fact the outlook for the IT sector in the last couple of quarters has actually improved.

Contrary to the fact that earlier we would have thought that because of the global slowdown, and with the slowdown in the IT spend will impact the growth-that was true for the first quarter, but I think suddenly, we’re seeing the spend moving in the new direction and Indian companies are well poised for that. So the outlook for next year, for CY21, we’re actually seeing some upgrades to that growth outlook and that I think bodes well for the IT sector. Also there are some headwinds from the U.S. dollar rate but overall, there is some amount of cost saving which is possible because of the current environment and we are actually seeing marginal improvement also going down for some of the companies. In fact, many companies are saying that a large part of their workforce will probably be working from home 2-3 years down the line and that could mean some amount of cost savings which could be there which can enable companies to maintain their margins or have an increase in certain cases. We are looking at the front line companies growing at around 8-9%; that would probably increase by two percentage points- around 10 to 11% growth next year, but that’s a reasonably steady growth when looking at this space. Now, with the kind of the cash flow generation some of the IT stocks have, I think they look very good in this current environment. There’s no doubt that the multiple sector has really gone up. Again, it’s nice to do with what’s happened in the U.S. tech space where we have seen the Nasdaq and all the technology companies being re-rated. So, on the valuation standpoint, if you look at the sector, it is actually at one standard deviation above its long-term average. It’s no longer cheap but I think earnings visibility and growth there looks better than what it was a couple of quarters back.

Yes, I think the good thing about Indian IT, though it’s not so high tech and has steady growth, they are good cash compounders. I mean the pack through the cash flow is almost 100% and a lot of these are also paying out a large amount of dividends and doing buybacks. So, that also helps to create investor wealth. So I think these are steady compounders, but I think in our fund we also started looking into overseas companies at two years ago to get a flavour of what’s happening globally, especially in the technology side and also on the cloud computing and also the internet space. There are a lot of companies listed outside India, in which we’d like to participate especially of the next generation companies and that’s an area we started to explore around two years back. That provides some amount of the diversity for investors to not only invest in this steady outsourcing story from India, but also to participate in the new generation companies and the technology high tech companies which are there in the U.S. In India we’ve seen that in the unlisted space. A few companies coming up for example, in the value added services. That’s what we’ve seen and come up a few IPOs over there to participate in that. But really, if you want to play large companies,they are there in the U.S. So a good mix of domestic as well as international companies I think can provide a steady kind of diversity and a good mix for Indian investors to participate in the overall technology story.

We believe that actually India and the U.S. are very different in terms of technology. India is a sectoral IT services play. However, I made this point on healthcare- if you look at all the innovative work that is happening in technology, you don’t have listed companies in India. If you look at themes like cloud, electronic payments- Paytm is not listed in India. Netflix, Amazon- so the whole OTT space, AI, machine learning and autonomous cars- I mean these are the five big themes in technology and technology for us is not a sector, it transcends all sectors. It’s there in auto, it’s there in entertainment and it’s there in BFSI. So technology is a broad based theme across sectors. We believe that the centre of innovation for this theme is actually the U.S. market, very much Silicon Valley, which is why the fund that we launched, and we launched this sometime in February in partnership with JPMorgan, is a U.S. technology focused fund andit focuses on identifying disruptive technology companies. So, it’s not hardware where penetration is capped out and it’s not Bitcoin which is completely new. Its companies which are at a scuff point. So it’s a multi-cap fund across the cap range about 60 names in the technology space and one of the things that we’ve seen is that this trend was already in place pre-Covid but even when you look at a year with Covid at a time when earnings growth and EPS growth for S&P 500 is probably -20 for S&P 500 technology as a sector, it’s still very positive. So, this has been the driver even in terms of earnings growth in the U.S. because people often talk about the valuations of U.S. technology companies. So in the U.S. tech fund which is a JPMorgan-run fund, we are looking at that segment of companies, really think disruptive technology.

So I will just make two points. One I get very nervous when people look at my own fund and look at the past performance of 50-60% and I think the viewers or investors should go into any category of a fund with moderate expectations. So, whether it’s Pharma’s last year returns or technology’s, I think don’t use that as a benchmark, you will get disappointed. Yes, we do believe that there is, and Covid is sort of a great driver for this, but there is an earnings growth story in U.S. technology as a space. However, please do remember again and I don’t want to be the devil’s advocate, both sectors, we talked about our sectoral funds so themes have their own volatility. So, please think through before investing but I think both the themes we talked about are compelling themes from an earnings point of view and from a fundamental point of view.