Dodge & Cox: The Pharmaceutical Industry Evolution

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The Pharmaceutical (Pharma) industry has long been a significant engine of the global economy. Throughout the 1990s, Pharma industry valuations were high due to expected industry growth, robust profitability, and overall optimism about scientific advancements. However, by the turn of the millennium, positive sentiment was decreasing in light of tougher FDA approval standards, health care cost scrutiny, and reduced research and development (R&D) productivity. By 2009, valuations plummeted to historically low levels as investors appeared to be questioning the viability of the traditional “Large Pharma” business model.

Through our bottom-up research process, we started to build conviction that this out-of-favor industry was going through a difficult cycle as opposed to a terminal decline. We performed extensive due diligence and identified several Pharma companies that we believed were undervalued. By 2012, we had accumulated a significant overweight position in the industry across the Dodge & Cox equity funds.

While we reduced the Funds’ relative weightings recently in light of higher valuations, they remain overweight the industry compared to their respective benchmarks. Looking ahead, we believe the Funds’ Pharma holdings stand to benefit from three key investment drivers—increased R&D productivity, growth opportunities in emerging markets, and durable business franchises—over our three- to five-year investment horizon. At current valuations, we remain enthusiastic long-term shareholders of companies in this industry.

In 2013, worldwide spending on prescription drugs exceeded $717 billion, with the top 10 best-selling drugs accounting for $75 billion. The Pharma industry is an important driver of the global economy, and we believe we have identified several companies within this industry that are particularly attractive investment opportunities over our investment horizon. We will discuss: 1) the investment process we used to establish overweight positions in the Pharma industry across the Dodge & Cox equity funds; 2) the pillars of our current Pharma investment thesis, and; 3) our valuation framework for analyzing such companies.

Overview Of Dodge & Cox’s Investment Approach

Dodge & Cox has operated with the same investment philosophy for over 80 years: we seek to identify well-established companies that have attractive long-term earnings and cash flow prospects not reflected in the current valuation. To select investments, we employ a consistent and disciplined approach that focuses on intensive bottom-up research, a long-term investment horizon, and a strict price discipline. Our valuation framework (discussed later) is an essential element of our investment strategy.

Investment risks and opportunities are evaluated on a company-by-company basis with each Fund’s sector and industry positioning a result of our individual security selection. As part of our decision-making process, we also consider external factors, such as industry trends, regulations, and geopolitical risk. To a greater extent than in many industries, such outside influences have an impact on Pharma companies’ results and long-term prospects.

Pharma Industry Evolution & Our Positioning

During the 1990s, Pharma industry valuations were high, reflecting significant optimism about the industry’s growth prospects. While the supply of capital for R&D projects was scarce, there was an abundance of R&D projects for companies to invest in, given the substantial unmet medical needs in primary care settings (e.g., high cholesterol, hypertension, depression, heartburn). Such favorable supply and demand dynamics yielded high returns for Pharma companies, which led them to expand discretionary investment in R&D. High valuations reflected the market’s optimism about advances in basic science and the persistence of high returns on R&D. Given these lofty expectations and valuations, the Dodge & Cox portfolios had little exposure to the industry.

Starting in 2000, consensus growth expectations for the overall industry began to decrease in light of tougher FDA approval standards, greater scrutiny of health care costs, and declines in R&D productivity. Industry concerns accelerated in 2004 due to the recall of Vioxx and the looming “patent cliff”— the potential for sharp declines in sales and profits when blockbuster drugs go off patent. The patent expiry of old drugs and R&D’s inability to produce new drugs led to lower valuations as investors became more pessimistic about Pharma companies’ future profits. The consensus appeared to be questioning the viability of the “Large Pharma” business model.

Dodge & Cox Pharma Industry 2

See full Dodge & Cox: The Pharma Industry Evolution  below.

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