MONEY W A T C H
2 0 0 8 S P E C I A L R E P O RT
Warren Buffett’s
two favorite stocks
for
1 Big Money Watch, Special Report, March 2008
Warren Buffett’s Two Favorite Stocks for 2008
The pharmaceutical industry may be ailing, but Warren Buffett has taken its pulse and predicts a recovery. His Berkshire Hathaway has bought into Glaxo SmithKline (Ticker: GSK) and Sanofi-Aventis (Ticker: SNY).
Firms today fall from grace with the alarming ease of wayward bishops; few industries, however, have tumbled as far, as fast and on as many fronts as drug makers. Ten years ago, big firms were celebrated as the purveyors of exciting new medicines, such as Viagra, and even more stimulating earnings growth. But it has all gone horribly wrong for the dozen or so manufacturers that make up “big pharma”. The withdrawal of high-profile drugs, growing suspicion among consumers about drug companies’ ethics, and arguments with regulators and customers have all dented what until recently was one of the least-tarnished of industries. A string of books has attacked the marketing tactics used by the industry, while lamenting the diminishing returns from its much-touted search for new drugs. Some observers have questioned whether a business model that was once capable of producing huge and reliable profits has been irreparably damaged. The industry is struggling to come to terms with a changing environment in its biggest and most lucrative market, America. The internal travails of the world’s leading drug makers have been compounded by a broader social debate about the purpose and practices of the industry, again mostly in America, which as the world’s largest drug market accounts for over 40% of global sales. American drug prices are largely set by the market, which has prompted pharma firms to invest here on a large scale. As a result, they have become a highly visible target for criticism. Europeans are far less exercised about the industry, in part because their drug bills are paid for mainly by their governments, and in part because they are shielded from pharmaceutical marketing. Today, firms are seen by many as more profiteering than profit making. Companies are castigated for spending billions on research and development, only to deliver too many “me too” drugs and too few
2 genuinely new ones. Comparable sums spent on sales and marketing – particularly on direct-to-consumer advertising in America – are lambasted for corrupting doctors and creating demand on the back of fancy publicity rather than legitimate medical need or product superiority. Efforts to fend off lower-cost competition from manufacturers of generic drugs through patent lawsuits leave companies accused of driving up the drugs bill in rich countries and depriving millions of life-saving medicines in poor ones. The shares of most big drug firms now trade at a discount to the market, as promises of bright times ahead are marred by risk. To be sure, pharma companies come in for criticism not just because they are more profitable than those in other sectors but because they are profitable in a field, medicine, where money makes people uneasy. And not only are drug companies profitable, but also visible: In America, rising hospital and physician costs are as much to blame for soaring insurance premiums as pharmaceuticals, but it is drugs which are the most obvious recurring expense and the one that consumers are asked, at least in part, to shoulder directly. Firms are caught between shareholders, who fear drug prices will fall, and consumers, who complain about their rise.
Prescription for change
Some of the pain which big firms now feel is undoubtedly self-inflicted. Firms were slow to recognize the gathering storm around the lack of access to life-saving drugs in the developing world. Their public relations on most other issues remain pretty clumsy too, and their promises to investors have been overblown. And yet it is also true that producing new drugs today has become a more complicated, costly and risky business than before and many firms now face a couple of years during which they will have relatively few new products coming to market. For example, using human genome to identify promising new treatments is proving a much more difficult scientific task than many had predicted, and it will be many years before the promised flood of new drugs occurs. Now pressures on pharmaceutical firms are forcing a long-overdue examination of how they organize research and development and these changes could cut the cost, in time and money, of R&D and eventually boost output. Drug firms, however, cannot be expected to achieve this on their own. Like all firms, they respond to incentives, and only more intelligent behavior by regulators and customers alike – whether the
3 public-health systems of Europe and elsewhere or the public and private insurance schemes of America – can provide the correct signals. Currently, many drug prices in America, for example, are set largely by what other drugs in the same class cost and how much others are paying. What prices should be based on is a rigorous assessment of the benefit, measured across various parameters, which a new drug brings to individual consumers and society broadly, above and beyond existing treatments. Admittedly, this is no easy task. But it is not impossible. Some countries in Europe, for example, have set up independent agencies to undertake such cost-benefit analysis.
The drug makers’ dilemma
However, governments often use such analyses solely to beat down prices, and are unwilling to reward genuine innovation when they find it by paying higher prices for better drugs. America, on the other hand, tends to pay for novelty without systematically assessing its value. Both European and American customers of the industry need to change. Companies are understandably wary of throwing lots of money into comparative trials only to show that their new medicine is not much better than a rival’s. And yet governments should encourage such trials, occasionally by providing direct financial assistance for them, but more often by promising to pay more for drugs that are significantly and demonstrably better. But most of the world’s big drug makers have to live with the whims of their investors, who over the past few years have been taking an increasingly short-term view of the industry. This is particularly true of hedge funds, which dip in and out of companies at will. The problem is that the respective cycles of the pharma industry and of investors are out of sync: stocks are bought and sold in an instant, whereas industry leaders stay in their jobs for five to ten years, and drug development takes even longer. Warren Buffett, of course, takes an even longer-term view. Which is why his Berkshire Hathaway has bought into Europe’s largest drug maker GlaxoSmithKline (Ticker: GSK) and increased its stake in Sanofi-Aventis (Ticker: SNY), another drug group.
GlaxoSmithKline PLC (Ticker: GSK)
This would seem to be a terrible time to be the boss of a big pharmaceutical company. Customers and regulators are fretting about
4 safety after the high-profile recall of Merck's Vioxx, a painkiller that turned out to be dangerous for some patients. The number of new drugs gaining approval has plunged in recent years, casting doubt on the industry's research model. Poor countries are making noisy demands for free drugs and are threatening to override patents through “compulsory licensing”. All this has battered the shares of the drugs giants and forced out the chief executives of three of the biggest in the past two years. And yet here is Jean-Pierre Garnier, the boss of $112.50 billion (market cap) GlaxoSmithKline (Ticker: GSK), beaming confidently as he defends his industry. “My generation of chief executives is the first that ‘gets it’,” he declares. What explains the ebullience displayed by J.P., as he is universally known? One reason is his successful defense of Avandia, a blockbuster diabetes drug that had threatened to go the way of Vioxx. A safety scandal blew up last May when a leading cardiologist published a statistical study suggesting that Avandia might increase the risk of cardiovascular problems. In the wake of the Vioxx scandal many drug companies have been eager to avoid messy confrontations over safety. But not Mr Garnier. He came out swinging, accusing critics of politicizing the regulation of drugs and rebutting the study's claims with his firm's own data. An expert panel convened by America's Food and Drug Administration (FDA) voted overwhelmingly to keep Avandia on the market, albeit with stronger warnings about potential side-effects. As one analyst put it, GSK “dodged the FDA bullet”.
The nimble sumo
Another reason Mr Garnier is smiling is that GSK has the strongest drugs pipeline of any big firm. It has 33 drugs in the late stage of clinical trials, with perhaps two dozen due to be launched between now and the end of 2009. That is much better than at rival firms, and far better than the pitiful prospects Mr Garnier inherited when he took over as boss of SmithKline Beecham in 2000, just before the merger with Glaxo Wellcome. The industry's poor research output has led some critics to argue that the huge mergers of the past decade have produced giant firms that are too big and bloated to innovate. Mr Garnier disagrees. “R&D productivity is not linked to size,” he insists. He invokes the image of a successful sumo wrestler and says giants can be nimble if they are clever. Indeed, size can be an advantage in marketing, or when organizing massive clinical trials, he observes. But he accepts that size is a problem early in the drug-development
5 process. “Drug finders” and innovators may well get tripped up by bureaucracy and tangled in red tape; good ideas are lost. Even worse, bad ideas may not be weeded out in time: Pfizer, for example, spent $1 billion to get Torcetrapib, a cholesterol drug, to late-stage testing only to discover dangerous side-effects that forced it to abandon the potential blockbuster. So Mr Garnier has tried hard to decentralize. He did away with GSK's topdown approach to research, replacing it with a number of autonomous research clusters known as “centres of excellence in drug discovery”. The idea is that these smaller groups will take many more “shots on goal” than bureaucratic research monoliths like Pfizer. Crucially, he wants them to fail more quickly too, thus sparing the firm the huge expense of a late-stage withdrawal. Surprisingly for an industry veteran, Mr Garnier has also taken on the tradition of secrecy by experimenting with “open innovation” models. Managers are now rewarded for successful inventions whether they were developed in-house or acquired from outside. He reckons this eliminates the “not invented here” syndrome common at big drugs firms. A driving force behind Mr Garnier's success is a brash self-confidence that even one of his lieutenants considers “arrogant”. The American-educated Frenchman, who lives with his family in Philadelphia, has ended up in hot water a few times as a result. In 2003 he was branded a “fat cat” by the press for trying to push through a $36m pay-and-benefits package. In a move rarely seen at a British firm, shareholders voted against the resolution. Mr Garnier now seems to have a healthy respect for shareholders, even initiating a recent share-buyback to appease their concerns about a weak share price. His instinctive cockiness also got him into trouble with developing countries. Soon after taking over as boss of GSK he found himself ensnared in a controversy over access to cheap HIV drugs, a row portrayed in the media as drugs giants cruelly ignoring the plight of dying Africans. Mr Garnier's first instinct was to fight. But although he was confident of his firm's legal position, he was losing the media war. So he chose to cut his losses and made a dramatic U-turn. “For the very poor countries of this world,” he explains, “we decided to sell our drugs completely not-for-profit.” GSK's attitudes toward the poor are now regarded as a model for others. The firm encourages generics-makers to produce its formulations, so costs can fall further. It offers tiered pricing, linking the price of drugs to a country's ability to pay and offering subsidies for the poorest. Even the World Health Organization, a United Nations agency not known for cosiness with the pharmaceutical industry, applauded GSK's decision last
6 June to donate 50m doses of its new flu vaccine to be held in an emergency stockpile. This transformation, of both GSK and of its boss, suggests there is hope yet for the pharmaceutical industry. “Society puts up with Big Pharma only because we come up with innovative drugs,” says Mr Garnier. At $41.86, GSK sells at 10.41 times forward earnings and yields an attractive 5.90%.
Sanofi-Aventis (Ticker: SNY)
R&D is the lifeblood of the pharmaceutical industry, but in the past few years many of the world’s large pharmaceutical firms have been looking a little anemic. The 1990s were a productive period, but more recently the number of new drugs launched on the global market has fallen dramatically. The problem lies not just in the numbers of new drugs, but in how truly novel and useful they are. A few new drugs fighting disease in new ways have come to market since 2000, particularly cancer treatments. However, critics point out that only a third of the drugs launched on the market in the past few years were first or second “in class”. The rest were “me-too” medicines, tackling the same problem in much the same way as existing drugs. Given that it takes an average of 12 years to develop a drug from start to finish – depending on the nature of the molecule and the disease it tackles – the drugs coming to market today reflect the investments, and the science, of a decade ago. The big question is whether today’s investments will yield better returns in the future. After all, striking it rich in drug R&D is a chancy business. Drugs fall be the wayside at every stage; for every 10,000 molecules screened, an average of 250 enter pre-clinical testing, ten make it through to clinical trials and only one is approved by the regulator. Since the mid-1990s, average success rates have declined, most worryingly at the later stages of clinical testing. Some of the reasons are structural. A wave of mergers over the past decade caused upheaval in R&D operations. Other contributing factors are commercial. One-third of all molecules fail to make it through clinical trials because it becomes clear that they will not justify further investment. But one drug maker’s reject is another company’s opportunity – and more big drug makers are licensing out their molecules to smaller drug makers or not-for-profit groups, or spinning out whole research teams into new companies.
7 The time it takes to bring a drug to market has increased, with the biggest rise in the clinical-trials phase. Drug makers often argue that because of increasing demands for data by regulators, the size and duration of clinical trials has fallen steeply, delaying the entry of drugs to the market and bumping up their R&D spending. Critics say that drug makers bring these problems upon themselves by running lots of trials simply to collect more data for marketing later on. Both sides have a point. But while the debate rages, $99 billion (market cap) Sanofi-Aventis (Ticker: SNY) has developed a new product line-up that boasts several drugs with substantial potential. Last October, SNY launched a new antihistamine, Xyzal, which is entering a market where competing drugs are losing patent protection. Also, while the FDA didn’t approve weight loss drug Acomplia in the U.S., it is performing well in Europe with close to $100 million in sales for 2007. In short, SNY’s pipeline has many mid-stage drugs with blockbuster potential, several of which are poised to enter Phase III trials in 2008. That ought to bolster the new product portfolio and help offset the eventual loss of the Plavix patent starting in 2011. All told, more than 40 products in SNY’s pipeline address diseases where there are no current treatments or use a novel approach to combating the disease. That SNY has one of the strongest pipelines in the industry has not been lost on Warren Buffett’s Berkshire Hathaway, which has steadily raised its shareholding in the company. At $37.07, on a forward p/e of 8.54, the stock yields 2.70%.