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If there is an industry recognized for its outstanding historical performance and broad future prospects, the pharmaceutical sector certainly has a place; if there is an industry that combines consumer and technology attributes, capable of steady defense in a bear market and aggressive offense in a bull market, the pharmaceutical sector also has a place.

In fact, whether it is in the U.S. stock market or the A-share market, pharmaceutical stocks have excellent performance records. The S&P 500 Equal Weight Healthcare Index, from 1990 to the present (August 8, 2024, same below), has an annualized return of 12.12%; the CSI Pharmaceutical 50 Index, from the end of 2004 to the present, has an annualized return (including dividends) as high as 13.37%.

Because of this, in the past three years of market adjustment, the pharmaceutical sector has trapped a large number of investors.

The same CSI Pharmaceutical 50 Index has seen an average annual decline of 22.06% over the past three years, with a cumulative decline of 61% from its highest point in February 2021. Based on a long-term belief in the pharmaceutical sector, many investors either increased their positions when the market fell or invested through fixed investments, both resulting in significant losses.

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What is the lesson? Buying low is always the key. It's not that the pharmaceutical sector was wrong, but buying at high levels was wrong.

Starting from 2017, driven by supply-side reform and the leverage of residents, the style of leading white-horse stocks in A-shares gradually became dominant. By 2020, public funds that heavily invested in the white-horse style were popular, attracting a large influx of funds, creating a positive feedback loop, and leading white-horse stocks gradually into a state of bubble.

As a typical white-horse stock, at the beginning of 2021, the valuation of the pharmaceutical sector also reached a high point, with the industry's static unemployment rate exceeding 60 times. A large number of investors began to engage in the pharmaceutical industry investment at this stage, entering at high levels. In the subsequent decline, to reduce costs, they bought more as the price fell, gradually increasing their positions, and suffered heavy losses.

From 2021 to the present, the pharmaceutical sector has been adjusted for three years, and the current industry valuation is at a historical bottom. From a fundamental logic perspective, over the past few years, the pharmaceutical sector has faced multiple pressures from policy, industry, demand, and the external environment, with valuations repeatedly hitting new lows. A brief analysis is as follows:

(1) On the payment side, it has faced the pressure of centralized procurement and medical insurance cost control. In recent years, to cope with the pressure of medical insurance expenditure under the background of an aging population, a series of reforms and rectifications based on cost control have been carried out in the medical field, including but not limited to, a significant reduction in the prices of drugs and devices under the pressure of centralized procurement; DRG/DIP reforms on the hospital payment side to control the cost of diseases; the implementation of a two-invoice system on the circulation side to squeeze out water, and the promotion of drug price transparency in terminal pharmacies; and the strengthening of anti-corruption in hospitals to carry out industry rectification, etc.

The result is that the expectation of a stable cash flow for pharmaceutical companies formed over the past decade has been broken, and pharmaceutical stocks have suffered a double kill in valuation and performance.(2) On the market side, the COVID-19 pandemic has caused high volatility in the pharmaceutical sector's performance. From 2020 to 2022, driven by a significant increase in demand during the pandemic, pharmaceutical companies' profits grew rapidly, obscuring the impact of factors such as medical insurance cost control. In 2023, the demand related to the pandemic plummeted, and the pressure of medical insurance cost control increased, leading to a substantial decline in profits for the pharmaceutical sector, which suppressed the valuation of the sector.

Taking the Pharmaceutical 50 Index as an example, the net profit attributable to the parent company of its constituent stocks dropped to 86.984 billion yuan in 2023, a year-on-year decrease of 29.1%. In the first quarter of this year, it continued to decline by 15.83%. Although the rate of decline has narrowed, it is still negative growth. The second-quarter report has not yet been released, but according to the statistics bureau data, the total profit of the pharmaceutical manufacturing industry in Q2 increased by 8.99% year-on-year, turning positive.

(3) Geopolitical factors have increased the uncertainty in the innovative drug sector. As China's innovative drugs are still in the initial stage, high-value new drugs globally are concentrated in European and American multinational pharmaceutical companies, and domestic CXO leaders' orders are highly dependent on the overseas market. Against the backdrop of deglobalization, the business prospects of domestic CXO companies have become more uncertain. Coupled with a high-interest environment, the activity of global venture capital investment in innovative drugs has decreased, leading to a significant devaluation of the innovative drug industry chain in the A-share market. Innovation is the driving force of the pharmaceutical market, and the lack of upward momentum in the innovative drug sub-sector, in turn, suppresses the valuation space of the entire pharmaceutical sector.

Speaking of this, have the aforementioned factors reversed?

In fact, they have not. Apart from the pandemic disturbance becoming a thing of the past, medical insurance cost control and geopolitical risks are expected to exist for a long time; otherwise, the valuation of the pharmaceutical sector would have bounced back already.

For the vast majority of investors, the correct way to invest in the pharmaceutical sector is not to predict the changes in national medical insurance policies in the next few months, the progress of leading companies' overseas expansion, or the impact of the U.S. biosafety bill, etc., as these are beyond our capabilities.

Investors should focus only on the long-term prospects and current valuations. The long-term prospects should be good, the development space should be large, and the current valuation should be sufficiently cheap. If these conditions are met, one can buy into the pharmaceutical sector and wait for changes to occur.

Currently, the valuation of the pharmaceutical sector is low enough, and the long-term development space remains broad, meeting the conditions for investment. In terms of changes, some positive factors are also fermenting, such as the normalization of pharmaceutical anti-corruption and centralized procurement, the global entry into a cycle of interest rate cuts, and the strengthening of domestic policy support for innovative drugs, which have significantly eased the factors suppressing the valuation of the pharmaceutical sector.

As for the long-term development space, it remains vast and promising. According to data from the National Health Commission, from 2013 to 2022, China's total health expenditure grew at an average annual rate of 11.6%, with its share of GDP increasing by 1.4 percentage points to 7%. Considering China's aging population trend, the increase in per capita income and health awareness, and the significant gap compared to major global countries (the U.S.'s healthcare expenditure as a share of GDP was 17.3% in 2022), China's total health expenditure is expected to continue growing at a rate higher than GDP. Accordingly, the fundamental prospects of the biopharmaceutical industry remain broad.

In terms of target selection, for ordinary investors, there is both bad news and good news about pharmaceutical investment. The bad news is that pharmaceutical companies are highly specialized and have a fast pace of innovation and iteration, with high research barriers and significant investment uncertainty. The good news is that as a whole, the pharmaceutical sector can achieve ideal returns through index investment. As Warren Buffett said in his 2008 letter to shareholders:"We don't know how to evaluate the drugs that pharmaceutical companies are developing. Even if we understand them now, in another five years, there will be a new batch of drugs in the research and development phase. We don't know whether Pfizer or Merck has more potential, or which one can develop a blockbuster new drug. What we do know for certain is that the companies we buy as a portfolio are reasonably priced, and their overall performance in the future should be good."

Similar words were spoken by Warren Buffett in 2002, "The long-term performance of the healthcare industry is very impressive. In 1993, we made a mistake by not investing in pharmaceutical stocks. It's hard to pick out the biggest winner, but a portfolio will definitely work."

Returning to the A-share market, we cannot predict when the pharmaceutical sector will welcome the right side, nor can we possibly select the stocks with the largest gains in the coming years. However, based on historical patterns, positioning in the pharmaceutical sector now and holding patiently will most likely yield good investment returns.