Prime Fund Recommendation: A beaten-down sector to pick up now

Getting into a sector when the going is rough can pay off as kinks get ironed out and prospects look up. The complexity of this sector, along with other factors, has led to steep underperformance against the Nifty 50. But with more clarity now emerging on sustainable growth from here as well as a shift in the contours of the sector, this may be an opportune time to build up exposure to this beaten-down sector.

Beaten-down sector looking up

The sector here is pharmaceuticals & healthcare. A combination of factors – price erosion in US generics, destocking, demand fluctuation, elevated raw material costs and freight costs – hit the margins of many listed pharma plays, especially those in the once-coveted API space. As a result, the growth of companies in the sector also remained in the low single digits over the past year. With a high base from Covid in FY-22, FY23 was also a difficult year to showcase double digit growth.

This performance was reflected in the stock market as well. The Nifty Pharma index fell 2.26% in the last 1 year as opposed to the 9.6% return by the bellwether index Nifty 50. The Nifty Healthcare index was flat at 0.82%.

However, with the base normalising and price erosion in the US cooling off, new launches by some of the large players and stronger growth in the domestic market may all help both margin and growth stabilise.

With 12 out of the 20 Nifty Pharma index stocks trading below their year ago prices and almost an equal number trading below their year ago valuations, we think this may be a good time to start taking limited exposure to the sector.

The moving average total value (MAT) of the Indian pharma market – which is the total sales value of the previous 12 months – suggests that the Indian pharma market is picking up. 

The Indian pharma market is expected to see linear growth as price hikes done earlier together with volume growth in key therapies such as respiratory, anti-infectives, pain management, gastro and derma are likely to continue to show growth. In the US market, while there is cautious optimism on price erosion abating, a few new launches by the large players together with the rupee depreciation can be expected to keep the US opportunity stable even as FDA warnings continue to remain a risk. 

It is important to note that the positive sentiment could well be restricted to select companies, depending on their normalisation post Covid as well as the erosion in their valuations. To this extent, stock picking in this space continues to be tricky.

For more details on the sector dynamics, do read the recent reports we have in our stock coverage:

1. Review of Mankind Pharma IPO
2. A pharma stock available at a bargain
3. A candidate in the drug discovery and outsourcing space

(You can get our stock recommendations in this space in Prime Stocks).

For moderate risk investors who do not want to directly enter stocks, the mutual fund route offers a good way to invest in the sector. Given that the pharma sector is very diverse in terms of opportunities, the mutual fund way can also help pick up growth across the sector. 

We have two recommendations here: 

• One, to directly play the index through a Pharma ETF and 
• Two, to take the active fund route to investing in the sector. This will also provide a more diversified portfolio, including other healthcare services outside of pharma.

Nippon India Nifty Pharma ETF

We added this ETF to our Prime ETF list in January 2023. With a 25% weight to Sun Pharmaceutical Industries, this index, like many other sector indices, is top-heavy; the top 3 stocks account for over 55% of the index. Dr Reddy’s Laboratories and Cipla take the second and third position in the index at present. These stocks have started seeing stock price action in recent months on the back of improving sales and volume numbers. Those that have seen price action have been driven by strong domestic and/or US growth as well as new launches. You can check the factsheet of this index here.

The data below will tell you that the Pharma index is beginning to outpace the Nifty 50 index in recent months.

The Nippon India Nifty Pharma ETF ranks among our higher-rated ETFs in the pharma and healthcare space. There are four other broad-based ETFs tracking the Nifty/S&P BSE healthcare indices (from ICICI Pru, Axis, Motilal Oswal and ABSL). However, all have lower traded turnover at present, leaving fewer options to play this theme. (You can check them in Prime ETF ratings) 

Suitability: If you want to play it safe and ride the market favourites in pharma, then go for this ETF. Buy lumpsum and add on market declines. We do not recommend SIPs. Keep exposure to 5-10% of your overall equity portfolio and remember that sector funds in total are best restricted to under 15-20% of your equity portfolio.

DSP Healthcare Fund

This actively-managed sector fund has been part of the sector/thematic recommendations in Prime Funds for a good while. This is among the more diversified healthcare funds in the actively managed space. In addition, it has a unique blend of up to 25% to global medical equipment stocks. Since the Indian market offers limited opportunities in this space, this blend can lend some flavour and differentiation to a portfolio. 

This fund beat the average rolling returns of all pharma and healthcare funds on a rolling 1-year return basis (over 3-year instances). It does not have sufficient record for rolling 3-year returns but in the instances available, it comfortably beat the peers but remained neck-to-neck with Mirae Asset Healthcare fund. 

The data below shows how the fund stacks up against the Nifty Pharma index. But do note that the abnormally high returns by both the fund and index is mostly driven by the high return period of 2020 and 2021. 

As a result of its more diversified portfolio (as opposed to the concentration in the index) and lower exposure (relative to the index) to key outperforming stocks such as Dr Reddy’s, the fund has been marginally underperforming the index over the last 3 months. However, it also makes it a better play than peers to capture structural growth in the sector over the long term.

Suitability: The fund requires a high-risk appetite. That it is an actively managed fund adds a further layer of risk to the sector risk. If you wish to hug the market, you will be better off with the ETF. This fund is a more diversified play than the ETF and holds potential to beat the index over the long term. However, for tactical exposure to ride a short rally, the ETF may fit better. Invest in lumpsum and add on dips. Do not expose more than 5% of your equity portfolio to this fund.