EquitiesMay 12 2014

Big pharma provides boost to healthcare sector

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Although the past five years, since the lows of the financial crisis, have witnessed an extreme and prolonged rally for equities, particularly developed market equities, one of the major components normally seen in a rally, merger and acquisition activity, has been largely absent.

In a buoyant market companies tend to be confident, tend to have a lot of cash to spend and tend to use that cash to buy other companies.

But that has not been happening since the financial crisis as, in spite of the improvement in equity markets and the gradual recovery in the global macro economic conditions, businesses have remained very hesitant to actually spend their cash in fear of another market crash or a recession.

However, in recent months M&A has returned to the markets, especially western developed markets, and it has been driven by the healthcare sector in particular.

Proposed deals, and other rumoured deals, have combined to boost sentiment to the healthcare sector - and have dominated headline to such an extent that debates have even extended to parliament. Most of the UK healthcare stocks have been propelled upwards in the process.

This movement in the healthcare sector has proved a significant boon to many UK-focused equity funds, especially equity income funds which tend to have quite a high weighting in the large pharmaceutical firms.

Deal-doing

The M&A activity began with a huge deal between UK-listed drug giant GlaxoSmithKline and Swiss pharmaceutical firm Novartis. The two firms decided to swap certain divisions between them and also to form a joint venture between their consumer health units.

As part of the deal, GlaxoSmithKline bought Novartis’ vaccines division for $7.1bn while Novartis took control of Glaxo’s cancer business for $16bn, with the two firm’s swapping divisions to both focus on their core, profit-generating activities.

Because GlaxoSmithKline received much more money from the deal from Novartis, it has pledged to return a significant amount of cash from the deal, around £4bn, to shareholders in the form of a special dividend.

The combination of the cash returned to shareholders and the positive reaction to the tie-up with Novartis from analysts meant that shares in GlaxoSmithKline rose substantially after the deal was announced, though it has since given back some of those gains.

Glaxo’s fellow pharmaceutical giant on the FTSE 100, AstraZeneca, has risen by far more in recent weeks following a potential takeover bid from US firm Pfizer.

The shares rose as soon as the first rumours came out that Pfizer would be interested in making a bid, but they have since surged even higher when Pfizer revealed it would look to make a bid that valued AstraZeneca at $100bn, which was a significant premium to AstraZeneca’s share price at the time.

The shares are now at £46, 24 per cent higher than when the rumours first hit the markets one month ago. The company continues to resist the advances for now, as politicians mumour about potentially intervening to protect a key source of jobs and demand assurance from Pfizer of benign intentions.

Jamie Hooper, who manages of the AXA Framlington UK Growth fund, says the market had been “slow to acknowledge the significant pipeline of immune oncology drugs for cancer treatment which could materially transform the growth prospects of [AstraZeneca]”.

He said: “Clearly Pfizer are looking to seize this opportunity with the aspiration of boosting their own oncology franchise and additionally delivering material cost synergies.

“As a theme for the wider market, large multi-national US companies have cash to spend, largely held overseas and typically subject to punitive rates of taxation if repatriated to the US. This trend may have further to run.”

Wider effects?

The proposed deal has since come up against a lot of political pressure, and AstraZeneca has said it undervalues the business, but the fact that Pfizer was willing to make such an offer has seemingly led investors in UK equities to conceive that there may be other healthcare M&A activity coming up.

Other shares in the sector, such as biotechnology firm Shire and medical devices manufacturer Smith & Nephew, have also been outperforming the wider index in recent weeks. The FTSE All Share HealthCare sector has outperformed the FTSE All-Share by nearly 7 per cent in the past month.

The boost to the sector has been a significant boon to a large number of UK equity and UK equity income funds. Data from FE Analytics shows that 352 funds within the IMA universe have GlaxoSmithKline within their top ten holdings, while 169 have AstraZeneca in their top ten.

The highest weighting in the two stocks comes from the SJP UK High Income fund, which Neil Woodford is currently managing, while his old Invesco Perpetual Income and High Income funds, now run by Mark Barnett, also still hold the massive weightings in both pharmaceutical firms that Mr Woodford put in place.

The boost to the healthcare sector overall has been a source of significant performance for the 24 UK funds that have a weighting of more than 15 per cent in healthcare stocks, which includes a number of equity income funds, but also Mark Martin’s top performing Neptune UK Mid Cap fund.

However, while the healthcare sector seems to have been the main beneficiary from M&A activity, Tom Becket, chief investment officer at Psigma Investment Management, says that it may not be the only sector to benefit.

He explains: “Many other sectors have also seen proposed transactions. In addition to the flurry of deals announced in the last couple of weeks, there are rumours of a number more in the offing, confirming the anecdotal evidence we had gleaned from contacts and clients in the legal sector that the M&A departments of big London law firms are working full throttle.”

Mr Becket says the pick-up in M&A would likely boost equity returns due to the “animal spirits coursing through markets”.

He says the recent “outburst” of corporate activity could keep going for some time, as businesses “[take] note of the positive share price reaction that acquirers have been enjoying”, and he said it could continue to offset the “possible downdraft in markets from unimpressive earnings and geopolitical fears”, providing support for the UK equity market.