The question uppermost on the mind of every serious stock market investor is: Should I invest in pharma stocks?

The reason pharma stocks are centrestage is because the pharma industry is readying for an upheaval.

Think product patents

Don't dismiss it as technical mumbo-jumbo. This is what has put the pharma industry in the limelight (and this is what will eventually impact you as an investor).

When a pharmaceutical company invents a new drug, it can apply for and obtain a patent from the government. This patent gives the inventor the right to exclude other companies from making and selling their invention in that country.

India, however, only recognises and registers the process patent. This meant Indian companies cannot copy the identical process, but they can manufacture the same drug using another process.

Hence, most Indian pharma companies (with the exception of a few) are not involved in the actual discovery of new drugs. Instead, they work on the model of reverse engineering to earn their profits. Reverse engineering refers to the process of disassembling the entire production process to find out how it a product or drug is created and then duplicating it.

This involves breaking down a patented drug and substituting its chemical combination. If they come up with the exact combination of various chemicals, they just have to replace them with chemicals with similar properties. The result is the same drug.

To be more specific, the Indian company will work on an international chemical molecule (say asprin) in such a way that they engineer a novel processes to make the same product. If a pharma MNC makes the molecule in five steps, an Indian company may make it in two. If the inventor uses boiling as a process, the Indian company may use heating instead to make the same drug.

So process patent means that another company manufacturing the drug of the inventor must change the raw material (at least a portion of it) and the processes.

Under the product patent regime, which is now under consideration in Parliament and will most likely become law, a drug patented by one company cannot be manufactured by another company. This means goodbye to reverse engineering. Companies can now file the patent for the drug with all the compounds and its associated chemicals.

So initially, Company A could make a drug using the XYZ process and Company B could make the same drug using the ABC process. Both would have a process patent.

Once the new law is passed, this will no longer be feasible. Now, if the innovator company has developed a product, then the product itself (and not just the process) is patented and cannot be replicated.

How will it affect the pharma sector?

Which, to you and me, translates into: How does it affect an investor who wants to invest in pharma companies?

Even as the new patent regime closes this easy road to profits, it might bring a windfall to many companies.

• Contract Research and Manufacturing Services players will benefit. 
  
  Contract Manufacturing refers to manufacturing licensed drugs for multinational pharma companies. Ditto for Contract Research. 
  
  This scenario is likely because of the availability of research skills in India. Besides, hiring research staff in India also proves cost effective. Thus, tie-ups in which the foreign partner outsources a part of the research work to its Indian counterpart are likely. However, such contracts will fall in the lap of only those Indian companies having excellent manufacturing assets and a proven ability to work with MNC clients.
  
  Examples include companies like Divis, Suven and Matrix.
  
• Considering that the cost of manufacturing a generic drug (drugs which are off product patent list) in India is half of what it would cost in a developed market, manufacturers of generic bulk drugs would throng to India in droves.
  
  This would help Indian companies like Nicholas Piramal [Get Quote], Cipla, Dr Reddy's and Ranbaxy [Get Quote].
  
• Apart from domestic pharma companies, the new product patent regime will immensely benefit MNC subsidiaries in India. Specifically, I am referring to those companies that have a strong product line-up and have sunk in billions of dollars in discovering new molecules.
  
  GlaxoSmithKline [Get Quote], Aventis [Get Quote], Abbott, Fulford and Pfizer [Get Quote] may report strong earnings and profit growth after the product patent regime comes into force.

What about mutual funds?

If you don't want to enter the stock market directly, you can do so via a mutual fund.

Pharma funds (mutual funds that invest in the shares of pharmaceutical companies) were the darlings of 2004. In fact, they led the pack of equity funds in terms of returns.

Take a look at the figures if you don't believe it.

During the one-year period from December 22, 2003 to December 22, 2004, the BSE Healthcare Index was up 18.56 %. But, the funds in this sector gained an average of a whopping 37.71%. They totally outperformed the benchmark (BSE Healthcare Index).

The winner was Magnum Pharma with a gain of 49 % -- clearly the best of the lot. It was followed by Franklin Pharma and UTI Pharma and Healthcare. The two new kids on the block were Reliance [Get Quote] Pharma (launched in May) and JM Healthcare Sector (June).

Looking into the crystal ball

Drug makers have been readying themselves to remain competitive in a product patent regime.

Analysts are of the opinion that, for the next two years, the Indian pharma market will be driven by growth from generic manufacturers. MNCs will rule the roost from 2006 onwards.

The long term impact would be seen in terms of increased investment in research and development-related activities.

Companies like Dr Reddy's, Ranbaxy Laboratories, Glenmark Pharmaceuticals [Get Quote], Sun Pharmaceuticals and Lupin are focussing on R&D.

Others like Nicholas Piramal and Elder Pharmaceuticals [Get Quote] have focussed on strategic marketing alliances and manufacturing capacity expansion.

The lesson

• Invest in the pharma sector only for the long-term. Don't look at short-term gains.
• Choose your companies wisely.
• Opt for a pharma sector fund if you don't want to buy shares of the pharma companies and would rather have an expert do it for you.

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Illustration: Rajesh Karkera