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Finding Value in Pharmaceuticals with Innovators and Cost-Reducers

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Over the past decade, the health care sector and the pharmaceutical industry have significantly outperformed the S&P 500 Index. Yet, valuations are relatively cheap, making health care, and pharmaceutical companies in particular, one of the few pockets of value in today’s richly priced market. In this issue of The Parnassus View, Parnassus Fund Portfolio Manager Robert Klaber discusses the rationale for Parnassus’s investment strategy in the drug industry using the examples of two companies with wide moats, highly relevant business models, seasoned management teams and compelling valuations.

Rising Costs and Greater Demand for Drugs

In our view, it is important to thoroughly review the business model and ESG (environmental, social and governance) practices of each potential pharmaceutical investment. The industry has received a lot of negative press over recent years, much of which has been deserved. For instance, some bad actors purchased small drug companies that hold patents, then slashed the acquired companies’ research and development and sharply hiked prices on the acquired drugs. More negative press—and a class action lawsuit—resulted when Mylan astronomically increased the price for EpiPen® last year.

Despite the preponderance of bad news, there are many drug companies that are focused on how their actions will impact patients and society. A strong case can be made for investing in well-managed drug companies, particularly as a steadily growing elderly population drives demand for innovative medicines. Forward-thinking pharmaceutical companies can help address the demographic and economic challenges evidenced by the following statistics:

  • Total expenditures for medicine in the U.S. rose from $195 billion in 2002 to $450 billion in 20161
  • One-fifth of the U.S. population will be age 65 or older by 2030, almost double the number from 20122, resulting in rising demand for effective medications
  • The costs of medicine for Medicare recipients rose 8.4% annually from 2013 to 2015, including hefty increases in the costs of arthritis, hypertension and diabetes drugs3
  • At least 2 billion people globally don’t have access to the medicines they need4
  • A Barbell Strategy for Identifying Drug Company Investments

    Parnassus takes a barbell approach to investing in the pharmaceutical industry. We focus on the most innovative companies and those that contribute to reducing drug costs. Innovators emphasize high-quality research and new discoveries that can improve human health, while cost-reducers bring to market generic drugs that provide patients with outcomes identical to those offered by expensive branded drugs, but at a fraction of the cost.

    We believe these two ends of the pharmaceutical business model spectrum—innovators and cost-savers—will be relevant for years to come. In a market defined by a growing older population, companies that offer breakthrough or more affordable drugs will be well positioned over the long term.

    The Innovators: Improving Medical Outcomes

    Gilead Sciences produces novel therapies for large patient populations. This company invests heavily in scientific research, has a robust new product pipeline and emphasizes access to medicine. While research and development necessarily involves a high level of risk-taking, Gilead avoids the outsized reputational and litigation risks that the bad actors in the industry are likely to face.

    Gilead, with its focus on antiviral medicines, develops treatments for a range of serious medical conditions, such as hepatitis C, HIV/AIDS and cardiovascular disease. Gilead brought to market the first treatment for chronic hepatitis C in single pills. Their chronic hepatitis C medication offers shorter treatment lengths and high cure rates for many patients. The hepatitis C market is now slowing, largely because of the effectiveness of Gilead’s treatment regimen. While this has weighed on Gilead’s stock, we believe the firm’s pipeline, under-levered balance sheet, robust HIV product portfolio and cheap valuation make Gilead a compelling investment. We’re also excited about the company’s recent acquisition of Kite Pharma. This deal moves Gilead into one of the most innovative areas of cancer research, chimeric antigen receptor T cell (CAR-T) therapy, which could be a multi-billion-dollar opportunity for the company.

    Although Gilead’s primary business is brand name drugs, the firm prioritizes access to its HIV/AIDS and viral hepatitis medicines in the developing world. They do this by establishing generic licensing and other partnerships to expand availability and make drugs available at deeply discounted prices. Approximately two-thirds of those treated for HIV in developing countries—10 million people across more than 130 countries—receive Gilead medications5.

    The Cost Reducers: Increasing Accessibility

    Sandoz is a generic drug company owned by Novartis with the dual missions of providing wider access to high-quality medicines and reducing costs for consumers globally. More than 500 million patients around the world utilize the firm’s generic drugs at substantial savings over branded products6.

    In addition to its focus on generics, Sandoz is a pioneer in the biosimilars industry. Biosimilars are the generic-like equivalents of sophisticated biologic medicines that are often used to treat complex diseases like cancer and multiple sclerosis7. Biologic medicines are very expensive, and biosimilars can help drive down costs by increasing competition in the marketplace.

    Sandoz was the first manufacturer to achieve approval for a biosimilar in Europe and in the U.S., and it is currently the #1 biosimilar company in the world. Sandoz is expected to launch five biosimilar drugs before the end of the decade, targeting major branded drugs that collectively generate more than $40 billion in sales. These launches will help the biosimilar market, which was valued at more than $3.3 billion in 2016, grow to approximately $10 billion by 20218.

    Advantages of Applying a Responsible Investing Lens to Pharmaceuticals

    Gilead and Sandoz have effective management teams, strong competitive advantages and long-term relevancy. They are both industry leaders, but what makes these companies stand out is that their core business models are aligned with their customers’ medical needs. Gilead emphasizes novel research to improve health, while Sandoz is dedicated to increasing accessibility by developing a wide range of generics and groundbreaking biosimilars.

    These very different business models share the goal of serving communities and improving lives. Parnassus’s support for both business types—and our avoidance of companies that seek only short-term profit at the expense of patients—is rooted in the firm’s investment philosophy as a long-term responsible investor focused on both principles and performance.

    klaber signature
    Robert J. Klaber
    Parnassus Fund Portfolio Manager



    1https://www.statista.com/statistics/238689/us-total-expenditure-on-medicine/

    2https://www.census.gov/newsroom/press-releases/2014/cb14-84.html

    3http://www.latimes.com/business/la-fi-medicare-drug-costs-20161123-story.html

    4https://www.forbes.com/sites/judystone/2016/11/13/new-pharma-rankings-on-global-access-to-medicine/#3081011536b4

    5http://www.gilead.com/responsibility/developing-world-access/hiv%20aids

    6https://www.sandoz.com/about-us/who-we-are/our-mission-and-purpose

    7Biologics and biosimilars are used in the treatment of disabling diseases. Their effectiveness is tied to their ability to target specific areas of the body. Biologics comprise complex genetically-engineered protein molecules or groups of molecules that are reproduced in living cell tissue, unlike branded or generic drugs that are manufactured using only chemical processes. Generic drugs and the brand name medicines they seek to replicate have identical active ingredients. Biosimilars must be highly similar to their reference biologic, but will not be identical because they are created in living tissue.

    8http://www.prnewswire.com/news-releases/biosimilars-market-worth-1090-billion-usd-by-2021-609759595.html

    As of 06/30/17, Gilead Sciences Inc. represented 4.8% of the Parnassus Core Equity Fund’s TNA, 4.4% of the Parnassus Fund’s TNA, 12% of the Parnassus Endeavor Fund’s TNA, 4.7% of the Parnassus Asia Fund’s TNA and 0.9% of the Parnassus Fixed Income Fund’s TNA (due 4/1/2024). Novartis AG ADR represented 2.3% of the Parnassus Fund’s TNA, 4.2% of the Parnassus Endeavor Fund’s TNA, 2.8% of the Parnassus Core Equity Fund’s TNA and 1.9% of the Parnassus Fixed Income Fund’s TNA (due 11/20/2025).

    The views expressed in The Parnassus View are subject to change at any time in response to changing circumstances in the markets and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or the Parnassus Funds.