Generics Could Be Exceptional

 | Nov 03, 2011 | 7:45 AM EDT
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We often read about the high cost of healthcare in this country. In fact, much of the world is faced with issues relating to rising healthcare costs. Perhaps the healthcare cost problems of other nations are not as acute as ours (because they spend less), but medical care costs are a global concern.

This is among the tailwinds propelling the generic drug market. When a proprietary drug comes off patent, generic makers step in and start selling lower-priced equivalents. But all is not perfect in this market. Competition is stiff, and after 2013, the value of patent expirations will decline. Of course, growth in the industry is heavily dependent on the expiration of patents of valuable drugs. That said, the generic drug market looks strong over the long term and should continue to perform well in the future.

The largest generic drug maker in the world is Teva Pharmaceutical Industries (TEVA), an Israeli company. In addition to generics, the company also has branded products, including Copaxone, a blockbuster multiple sclerosis drug that will lose patent protection in May 2014. Teva, which refers to itself as one of the top 15 pharmaceutical companies in the world, operates in 60 countries. It earns high grades from my Peter Lynch strategy, which is based on the writings of Lynch, one of history's most successful mutual fund managers.

Another generic drug maker that is a favorite of the Lynch strategy is India-based Dr. Reddy's Laboratories (RDY). In addition to its generics business, Dr. Reddy's sells pharmaceutical services and active ingredients as well as proprietary products for which it conducts R&D. These focus on metabolic diseases, anti-infectives and inflammatory disease. The company has a reputation for being a low-cost manufacturer and is pushing into developed markets such as the U.S. and Europe.

The linchpin of the Lynch strategy is the P/E/G ratio. This is the P/E ratio relative to growth and measures the cost of growth to the investor given the stock's current price. A P/E/G of 1.0 means a 1% increase in growth costs $1. This is the maximum the Lynch strategy wants to pay for growth; generally, the lower of the P/E/G, the better.

Total debt-to-equity is another ratio considered by the strategy, with less debt being desirable. Also factored in is inventory relative to sales, and the strategy does not want to see inventories increasing faster than sales, though it does allow an increase of up to 5% if all other ratios appear attractive.

Teva's P/E/G, based on its P/E of 11.20 and growth rate of 29.25% (which is derived from the average of the three-, four- and five-year historical growth rates), is a very strong 0.38. A P/E/G of 0.50 or less is particularly desirable. Its equity is about 4x its debt, which is perfectly acceptable, and its inventories relative to sales have remained constant.

Dr. Reddy's P/E/G is a solid 0.79, which comes from its P/E of 22.81 and growth rate of 28.95%, based on its three-, four- and five-year historical EPS growth rates. Inventories are up slightly relative to sales but not enough to be a problem, and debt is a bit high but acceptable.

The demand for generics is likely to increase. These two companies are important players with solid market positions and should do well over the long term.

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