Risk adjusted Vs absolute returns on pharma companiesNothing ventured, nothing gained is a popular Spanish proverb elucidating that taking risk is a prerequisite for expecting any higher return.

Unfortunately, that’s not always the case in the world of investing. At times, investors invest in companies which have ‘ventured’ and taken risk, but have failed to achieve the commensurate returns. Pharma sector in India is a case in point that has several such companies.

Many pharma companies in India have attempted risky business models, but this has not necessarily provided higher or better returns to their shareholders.

An analysis shows that the companies which otherwise top the list when compared only on the basis of absolute growth may not top the list when sorted in order of risk-adjusted growth rates. This makes the stocks of such companies unattractive in a long-run because of relative unpredictability of future earnings.

Pharmaceutical sector in India is a mixed bag of generic companies following variety of business models. While some companies are only present in the domestic market, there are others that have chosen to do business in large regulated markets of US and Europe.

Some companies have employed their marketing & distribution strength to market (under license) drugs owned by MNCs. There are still few others, which are investing heavily in drug discovery and have attempted to shift from being a generic company manufacturing copycat drugs to launching new molecules. While the sector as such is fairly defensive, the events of recent months have shown that there is nothing sacrosanct about the defensiveness of individual companies that follow risky business model.

Growth in the $10 billion Indian market couldn’t provide the scale to ambitious pharma companies that eyed the $ 300 billion US market – the world’s largest pharma market – as the destination to achieve scale. A mere 2% share in the largest market in the world could quadruple the size of even the largest Indian company.

However, unlike the domestic market where value-addition through branding and marketing allows the companies with multiple tools to augment earnings, being a low cost producer is the only competitive tool available to Indian companies to thrive in US and other regulated markets.

Over dependence on cost competitiveness however comes with its own set of risks –increased scrutiny and clamps from drug regulators, legal risks in challenging patented drugs and rising pricing pressure as regulated markets overhaul their healthcare systems. Indian generic makers have also been on defensive due to a general shift from branded drugs to unbranded generics market.

Companies that have acquired assets or businesses abroad have also taken hit as global economic slowdown has made their overseas operations financially less viable. Added to these woes, the volatility in currency movements have also made the earnings volatile for companies with cross-country operations. All these risks have increased manifold in recent period.

And the risk is more in case of companies wherein contribution of overseas market to the total revenues is much more than that of domestic market. Take the instance of Ranbaxy, which has grown its topline by more than two and half times in last eight years while net profit peaked at Rs 774.6 crore in year ending 2007. Last year the company posted a loss of Rs 951 crore. In case of Dr Reddy’s Laboratories, the topline has swelled four times over the same period, while the bottomline has nearly halved!

Amidst this volatile environment, the best bet for investors is to look for companies offering the best risk adjusted return rather than the best absolute returns. This is because; the best absolute returns can be a result of few excellent quarters but without any consistency.

The Group analysed the results of top 16 pharma companies and calculated the average growth rates of their net sales, operating profits and net profits over a ten-year period since 1999 on trailing fourquarter basis. Standard deviation of these growth rates has been used as a measure of risk. Further, the average growth rate is divided by the standard deviation to arrive at risk-adjusted growth rates. The companies have finally been ranked as per their best riskadjusted growth rates in operating profit.

The results of this exercise bring out Cipla, Divi’s Labs, Sun Pharma, Cadila Healthcare and Piramal Healthcare to be the best contenders on a risk-adjusted basis. Most of these companies have strong businesses in domestic market, which brings stability to their earnings.

Sun Pharma, despite having significant business in US, has been able to register stable growth in its returns. Its stock performance accordingly has grown at a fairly steady pace. Glenmark and Jubilant Organosys are closely trailing this set of companies. All these companies, while having the highest risk-adjusted returns amongst their peers, have also registered operating profit growth of more than 20%.