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With the recent downgrading of pharma sector because of expected lower margins due to intense competition in the generic market, only companies with strong R&D are expected to perform well. Should one continue to hold investment in pharma funds for some more time or scan the market for alternatives immediately? -- Autar Dhesi

We have a sanguine view of the prospects of the pharmaceutical sector over a two-to-three year period. This view recognises the likely competition in generic markets, even as drugs with a market potential of about $40 billion are expected to come off patent in the US over the next four years.

The generic market would be substantially smaller in size; profitability levels would also decline; there is also the risk of existing patent-holders resorting to every trick in the rule-book to evergreen patents for a few more years. This could also shrink the market for generics.

Even if one factors in these aspects, the market would still be large enough to offer scope for Indian companies to pursue growth.

Serving as a source of outsourcing for several drugs and/or having a steady pipeline of products to replace ones that are ravaged by competition — as in the case of Ranbaxy's experience with Ceftin in the US markets — would provide a base of impressive growth.

Several Indian companies are well-placed to tap into this opportunity. As you have rightly mentioned, strength in R&D would be crucial in this context. Quite a few companies have also adopted practices that respect intellectual property rights and business models that do not conflict with their customers.

These aspects are likely to strengthen the outsourcing story over the next few years; this trend may gain momentum once the long-awaited changes to the Patent Act take effect in January 2005.

Dr Reddy's strategy of mounting challenges on drugs under patent to gain a longer period of exclusivity has faltered in the latest case against Pfizer; mounting legal costs add to the strain on profitability. By opting for a less aggressive strategy, and yet having a steady pipeline of products, Ranbaxy has been able to ensure steady revenue growth.

Across the spectrum, Indian pharma companies have a range of business models that should deliver attractive growth.

What the recent decline in stock prices has done is to price out the effect of outsourcing hype as well as a massive dose of liquidity chasing few stocks in the sector.

Stocks from this sector are unlikely to provide the kind of spectacular returns of the 2003 kind. Over a two-to-three year period, steady returns are likely to accrue; this sector can be expected to outperform the broad market.

In this backdrop, we feel that it would be premature to exit pharma funds now; SBI Magnum Sector Pharma Fund with a portfolio tilted in favour of Ranbaxy and mid-cap pharma stocks appears better placed now to deliver superior returns. The risks are higher; these have been more than adequately compensated by higher returns.

The Franklin Pharma Fund and UTI Pharma & Healthcare Fund focus more on the larger Indian and MNC companies, and have underperformed their SBI MF peer over the past year. Over a longer time-frame of three years and beyond, the gap in performance is narrow. The Reliance Pharma Fund is yet to complete the process of investing the funds at its disposal.

We would recommend a hold strategy now; but ensure that pharma funds are only a part of your equity portfolio.

S. Vaidya Nathan

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