Stock Market

Since March 2009, the stock market has been virtually unstoppable. At one point in January 2018, all three major indexes — the Dow Jones Industrial Average, S&P 500, and Nasdaq — had essentially quadrupled from their Great Recession lows.

Of course, such a massive move in the broader market likely has investors wondering if stock valuations have gotten ahead of themselves. One industry, though, where that doesn’t appear to be the case is with drug developers (i.e., pharmaceuticals and biotechnology).

According to data provided by market analytics company Yardeni Research, the forward price-to-earnings (P/E) ratio of the broad-based S&P 500 is 16.6, but it’s just 13.7 for pharmaceuticals and 12.6 for biotechnology, as of May 24, 2018. That’s one of the lowest forward P/E readings for biotech over the last 21 years, and certainly toward the bottom of the forward P/E range for pharmaceuticals since 1997. Only the years immediately following the Great Recession appear to have offered a cheaper buying opportunity in big pharma stocks, at least based on forward P/E.

What’s particularly intriguing about drug stocks is that they offer an inelastic product. By this I mean that we don’t get to choose when we get sick or what ailment we contract. This creates a steady stream of demand for drug companies that translates into predictable cash flow, strong pricing power, and healthy profits.

Get these cheap drug stocks on your radar
Yet in spite of their product inelasticity, some drug stocks are downright cheap. There are currently three with a forward P/E of less than 8 that I believe investors could safely buy right now.

1. Celgene: Forward P/E of 7.7
Biotech blue-chip Celgene (NASDAQ:CELG) is a company that I recently added to my portfolio after what amounts to a nearly 50% tumble since October. Celgene’s stock has been hit by a multitude of problems, including concerns that it’s too reliant on multiple myeloma drug Revlimid, an embarrassing delay in filing its would-be multiple sclerosis blockbuster ozanimod, a sales slowdown in anti-inflammatory Otezla, and a 2020 guidance revision that lowered both sales and profit estimates this past October.

While these concerns aren’t worth sweeping under the rug, Wall Street has treated Celgene like damaged goods when it’s clearly not.

For example, Celgene was able to settle patent litigation concerning Revlimid back in December 2015 with a number of generic drugmakers. In doing so, Celgene kept the bulk of generic entrants out of the market until after Jan. 31, 2026. Any future challenges to Revlimid’s patents will likely be dealt with in a similar fashion. Despite accounting for close to 65% of the company’s total sales, it’s hard to argue against a drug that continues to deliver double-digit sales growth as a result of increased demand, longer duration of use, incredible market share, and healthy pricing power.

Though the ozanimod filing delay is disappointing, it’s not as if Celgene doesn’t have other things going on in its pipeline. It has the ability to expand the labels of existing drugs, and has more than 40 active collaborations, many of which are licensing what could be first-in-class cancer or inflammatory medicines. Even if we have to wait a few years for ozanimod to make its debut, it shouldn’t hurt the drugs’ more than $4 billion peak annual sales potential.

And thanks to steady growth from Celgene’s oncology portfolio, it sports one of the lowest price/earnings-to-growth ratios (PEG ratio) in the industry. Generally speaking, any PEG ratio around 1 is considered “cheap.” Celgene’s PEG ratio is currently under 0.5. It’s a plain-as-day bargain in my eyes.

2. Teva Pharmaceutical Industries: Forward P/E of 7.8
Another down-on-its-luck drug stock is Israel-based Teva Pharmaceutical Industries (NYSE:TEVA). Like Celgene, it has a laundry list of reasons why it’s struggled of late. This includes ongoing weakness in generic drug prices, a generic entrant to multiple sclerosis drug Copaxone (Teva’s top-selling drug) making it to market, fraud allegations being levied against the company, and plenty of executive turnover. Last year, Teva reduced its full-year sales and profit forecast multiple times and completely shelved its dividend.

While Teva is certainly in worse shape than Celgene, I’d suggest that it’s been unfairly written off given its still-strong profitability, as well as its significant generic-drug market share. Even though hindsight is 20/20, and Teva did overpay to acquire Actavis from Allergan, Teva’s enormous generic portfolio should allow for significant pricing power in the years to come. Plus, with the global population aging, the world’s leading generic drug producer isn’t a bad place to park your money.

As a shareholder in Teva, I’ve also been impressed with the no-nonsense approach to deleveraging the company’s balance sheet. Teva has sold all of its Women’s Health operations (for a better price than expected, may I add), halted its dividend, saving more than $1 billion annually in the process, and announced job cuts that’ll see a quarter of the company’s workforce let go. All told, Teva could reduce its annual operating expenditures by $3 billion, or about 16%, between 2017 and 2019. This should allow the company to make significant headway on paying down its debt.

And I’m not the only one who sees value in Teva. Warren Buffett’s Berkshire Hathaway initiated a position in the company during the fourth quarter and added significantly to that position during the first quarter.

Though this is a work in progress that’ll require the patience of shareholders, the worst appears to be over. What’s left is a company with a massive generic drug portfolio and healthy cash flow that’s valued at less than eight times Wall Street’s profit projections in 2019.

3. Innoviva: Forward P/E of 6.8
Lastly, there’s Innoviva (NASDAQ:INVA), which isn’t a traditional drug stock, per se. Innoviva is a royalty company that’s currently reaping benefits from a group of long-lasting COPD and asthma medications that were developed in cooperation with GlaxoSmithKline (NYSE:GSK). You know these medicines today as Breo Ellipta and Anoro Ellipta, to name a few.

Four years ago, Innoviva’s management team was a bit too giddy about Breo’s and Anoro’s prospects and wound up completing a private placement of $450 million in debt. This funding was to “support the initiation of a capital return strategy to the stockholders of Theravance, Inc. (Innoviva’s previous company name) in conjunction with the previously announced spinoff of Theravance BioPharma.” Unfortunately, GlaxoSmithKline struggled to gain insurer coverage for these next-generation therapies out of the gate, causing Innoviva to abandon its $0.25-per-quarter dividend after five quarters of lackluster royalty payments. It has since been digging its way out of debt.

Now, the good news. After those initial hurdles, Breo and Anoro are both seeing steady growth, which has, in turn, lifted Innoviva’s top and bottom lines. During the first quarter, GlaxoSmithKline reported respective constant currency sales growth of 14% for Breo and 68% for Anoro, with Trelegy Ellipta, another partnered drug with Innoviva, recently launching.

Because Innoviva is comfortable relying on royalties to do the heavy lifting, it has virtually no costs, aside from general and administrative. This lack of research and development costs means Innoviva can be very profitable with a relatively small amount of royalty revenue. It’s also allowed the company to prepay a significant portion of its $450 million loan, as of its latest quarter. It’s not out of the question that Innoviva will begin paying a dividend a few years down the road, once its secured debt is wiped off of its books.

Looking forward, Innoviva has an opportunity to grow its royalty revenue by close to 50% between 2018 and 2021, according to Wall Street’s estimates. Even taking into account its concentration of royalty revenue from its Glaxo partnership, a forward P/E of less than 7 seems cheap.