Why you can invest in Nippon India Nifty Pharma ETF NFO

Nippon India has launched a new sector ETF to track Nifty Pharma Index. This index constitutes the ten top Indian pharma companies by market capitalisation (free float). The NFO will close on June 28, 2021 . The fund is targeted at investors who wish to participate in the growth opportunities offered by the Indian pharmaceutical sector in a passive manner, avoiding the risk associated with individual stock selection.

However, sectoral ETFs carry high risk too. The Nifty Pharma index is made up of the largest pharma companies, including Sun Pharmaceuticals, Dr. Reddy’s, Cipla, Lupin and Cadila with largely similar exposure profile: exports (dominated by US), domestic, and third party API sales. Other constituents such as Aurobindo and Biocon are largely export oriented while Alkem and Torrent Pharmaceuticals are domestic focussed.

Divi’s Labs, with exposure to its CRAMS/custom synthesis business, is present as well. CRAMS operations have gained from higher outsourcing in the last five years and the Indian API industry is expected to gain similarly from supply diversification. Post Covid-19, increased healthcare focus by individuals and governments across regions is expected to translate positively for exports and domestic formulations business including vaccine opportunities.

The index rebalances semi-annually based on free float and currently excludes large API focussed operators because of its criterion. Two other index ETFs were launched in May 2021 from ICICI Prudential and Axis, both of which track Nifty Healthcare Index. This index constitutes 20 stocks including three hospitals/diagnostics and remaining 17 from pharmaceuticals. Also, these ETFs have a wider coverage of pharmaceutical stocks including APIs and Indian arms of Pharmaceutical MNCs, compared to the 10 companies tracked by Nippon’s Nifty Pharma ETF. Even as past performance is not indicative, Nifty Healthcare index with 6 per cent CAGR returns in the last five years returned similar to 5 per centCAGR returns from Nifty Pharma index.

Two factors based on historical data, can support a bullish stance on the pharma sector even from this point of elevated stock prices. The Indian pharma industry is coming off a protracted period of industry contraction in the last four years, which inflates the effect of recovery witnessed in the last year. The trailing P/E multiple for the Index as of June 2021, at 36 times, is still some distance from the last decade’s average.

Valuations still reasonable

In the first half of the decade from 2010, the rally in Indian pharma stocks was based on successful launch of limited competition generics in regulated markets utilising loss of patent exclusivities. But the last 3-4 years were marked by client consolidation, increased competition and regulatory challenges in the form of longer approval cycles and adverse plant inspection results. The Index eroded from late 2018 right up to the low point in March 2020. The recovery in the last year was thus on a low base.

The trailing P/E multiple of the index as of June 2021 is trading between lower limit (marked by one standard deviation) and the average of the last decade even as Nifty Pharma index, on an absolute basis, has marginally breached the peak reached earlier in the 2015-16 period. The index, on an absolute basis, appears strong, especially when considered against the last three years’ performance. But on a valuation basis, it seems undervalued and may prove to be a reasonable entry point to long-term investors looking for exposure to passive investing in the Indian pharma space.

Prospects sanguine

From a forward looking view as well, the industry has shrugged off the challenges of the last decade by focussing on moving up the value chain. R&D and other investments of the last four years, necessitated by contraction in US markets, will stand it in good stead in the coming decade. Each of the index constituents focusses on a niche amongst speciality products, biosimilars, vaccines, injectable and complex inhalation products, besides core operations.

Investors can gain from cumulative exposure to these long gestation projects, especially when speculating on company-specific long-term outcomes may seem fraught with risk, either through actively managed funds or individual stock selection. The main risk associated with the sector is that investors have to look out for is companies failing plant inspections by regulators and heightened inspection cycle, post the re-opening of economies.