We recently compiled a list of the 10 Cheap Pharmaceutical Stocks to Buy According to Short Sellers. In this article, we are going to take a look at where Haleon plc (NYSE:HLN) stands against the other cheap pharmaceutical stocks.

The pharmaceutical industry is one of the most interesting sectors to invest in. This is because while most industries can easily be broadly categorized into either being vulnerable or resilient to economic headwinds, pharma companies have the potential to operate in both categories. Firms that develop new drugs, particularly those that operate in the biotechnology industry, don’t do well in a tough economy as they find it difficult to raise capital and keep costs under control. At the same time, large pharmaceutical companies and those that develop and sell generic drugs can survive in a tough economy due to the relatively inelastic nature of their product demand.

As is with all other industries, the pharma industry has also changed throughout the past few decades. This change has been driven by the rise of biotechnology and biopharmaceutical companies that are seeking to open new frontiers for drug development. Before we get to the data, some of the shifts that have taken place include increased spending on acquisitions as opposed to solely on research, a global industry where multinationals operate in multiple markets, and marketing campaigns that seek to extend product life cycles as opposed to maintaining competitive advantage through patents.

Talking about data, biotechnology has been catching up to the pharma sector in terms of revenue, as it accounted for 30% of total pharma sales in 2014 compared to less than 1% in 1991. At the same time, biotechnology operating margins have also been catching up. These ranged between roughly 7% to 12% between 1991 and 1993, were in the red for the next decade until 2024, and surpassed pharma margins of roughly 24% in 2014 to sit at approximately 28%. This gap widens when we remove the impact of R&D which disproportionately impacts biotechnology companies, as for the five years between 2010 and 2014, the pre R&D operating margin of pharma companies declined from 40% to ~28% while the corresponding value for biotechnology firms grew from 40% to ~56%.

During the same time period, biotech firms’ growth to R&D ratio (which measures the growth per unit of R&D per unit of sales) sat at 0.95, more than 10x of the pharma sector’s 0.08. This stellar catch up of biotechnology is also visible in pharmaceutical valuations, since in 2014 biotechnology companies accounted for roughly 40% of drug company valuations for a historic high. In terms of multiples, namely enterprise value to pre R&D operating income, the biotech sector’s premium has noticeably dropped over the pharma sector. It sat at a high of ~77x in 2000 and dropped to ~18x in 2014 for a markedly lower premium over the pharma sector’s ~11x which had sat at 20x in 2000.

Building on this, while the market level valuations of pharma companies have shifted over the years due to the growth in biotechnology companies, this does not provide us with any details about what drives firm level valuations. On this front, research that used ten year data from 101 firms demonstrates that the three key drivers of pharma valuation are R&D, advertisement, and production facilities. These three have regression derived valuation weights of 13.19, 15.85, and 19.13, respectively. This provides key insights as it suggests that R&D is far from being the key competitive edge in the industry as is commonly believed.

In fact, advertising and production are key drives for pharma valuations when we consider the biggest thorn in the industry’s side, namely patents. 2024 has seen weight loss drugs cement their place in the market, and as their patents start to expire, the industry and the government could enter more thorny fights that could impact pharma valuations. The industry’s detractors accuse pharma firms of unsavory practices such as filing ancillary patents that extend patent lifetimes by filing patents for different features of the same product, filing differently worded yet similar patents in what is called building patent thickets, and purposefully delaying upgrades to benefit from evergreening provisions.

While it might seem that this potential disruption to the pharma sector is far off in the future, the reality is different. This is because GLP-1 based weight loss drugs, liraglutide, albiglutide, and dulaglutide, were first approved by the FDA in the 2010s and firms in India and China have already started working on making cheap biosimilars that could attract a wider market. Things are moving fast even in the developed world as the Indian firm Biocon has already secured approval for a liraglutide generic in the UK while the FTC sent letters to ten companies, including some of the biggest weight loss companies, in May as part of its bid to fight bogus patents. Looking forward, you should expect the number of generics to rise and patent fights to intensify since the weight loss pie could be as big as $100 billion by 2030 according to a well known investment bank.

Our Methodology

For our list of best pharma stocks to buy according to short sellers, we ranked specialty and general drug manufacturers with a market cap greater than $300 million by the percentage of shares outstanding that were sold short and selected the stocks with the lowest percentage. Then, those stocks with a trailing P/E ratio lower than 57.63 or a current P/E ratio lower than 38.94 were chosen. These are the sector averages for the pharma industry.

For these stocks, we also mentioned the number of hedge fund investors. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).

Dozens of pharmaceutical capsules piled on top of one another to show the scale of the company’s drug contributions to the industry.

Haleon plc (NYSE:HLN)

Short Interest as % of  Shares Outstanding: 0.34%

Number of Hedge Fund Investors In Q2 2024: 18

Haleon plc (NYSE:HLN) is a British firm that sells over the counter drugs and consumer healthcare products. This makes it a relatively stable company that doesn’t have to compete by investing heavily in R&D or taking the risk of regulatory headwinds. Its business model also means that Haleon plc (NYSE:HLN) can benefit from beefy margins. The firm’s trailing twelve month gross margin is a strong 59%, which makes it important for it to maintain this trend in order to maintain its current trailing P/E valuation of 32. Haleon plc (NYSE:HLN) is also currently aiming to bring the erectile dysfunction drug Eroxon to the US, which has contributed to a slight margin erosion this year. The margins can drop in the future too, given that the firm has benefited from pricing power over the past months due to historic inflation in the UK and worldwide. Along with margins and pricing power, volume is another key factor in Haleon plc (NYSE:HLN)’s story.

Haleon plc (NYSE:HLN)’s management commented on its margins during the Q2 2024 earnings call:

“So when you look at last year, last year Half 1 was 9 and Half 2 was 12, so we’re cycling over a much stronger Half 2 from prior year. And then there’s really 4 reasons why organic profit growth is going to be lower than the 11% we’ve seen in Half 1. And I think you already mentioned 2 of – or one of them in your question, Iain. So I think the biggest one really, and I’m going to do the order of sort of sizing and magnitude. The first reason it’s going to be lower is the phasing of the cost inflation. Cost inflation was really at its highest point in Half 1 of last year, and then, we saw costs starting to come down in Half 2 of last year. And you saw that come through in our Q4 margin last year when gross margin started to grow than – ahead of the rate of sales growth.

So Half 1 was really a low prior gross profit comparator. So as we get into Half 2 this year, we’re going to start lapping the benefit of those lower costs. And usually, you have this normal time lag when the costs come in until they run through inventory to come up. So that won’t repeat in Half 2 of this year. Then the second reason is the one you mentioned, Iain. So yes, A&P growth will be higher in Half 2 than it was in Half 1. And also here, a reminder, last year, A&P in Half 2 was only up 1%. So – and then in addition, we’re going to fully support the launch of Eroxon in addition to continue investing in the brands that deliver the growth, so continued high and strong investment into the launches we made, especially clinical wide on Sensodyne and on the high-growth drivers like Centrum, plus all the geographic expansion that is running.”

Overall HLN ranks 6th on our list of the cheap pharmaceutical stocks to buy according to short sellers. While we acknowledge the potential of HLN as an investment, our conviction lies in the belief that some AI stocks hold greater promise for delivering higher returns and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than HLN but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.

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Disclosure: None. This article is originally published at Insider Monkey.