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Innovation Fortifies Drug Company Moats

August 07, 2020

Read Time 5 MIN

 

The Morningstar® Wide Moat Focus IndexSM (the “Index”) has had an overweight position to the healthcare sector relative to the S&P 500 Index at many times historically. Often, its overweight has swung to an underweight if companies in the sector begin to appear less attractively priced based on the Index’s quarterly review process, which is intended to identify opportunities to allocate to undervalued wide moat stocks. In recent years, there has been a persistent overweight to health care stocks ranging from modest to significant. The Index’s overweight to healthcare registered at approximately 4% at the end of July but was as high as 10% earlier in the year and even higher in early 2018. This overweight is driven in large part by pharmaceutical and biotechnology companies.

Morningstar’s healthcare strategist, Karen Andersen, and director of healthcare equity research, Damien Conover issued a report last week, “Innovation Supports Growth at Big Pharma/Big Biotech Companies,” covering many recent and current members of the Index.

Patents and Pipelines 

Drug companies tend to benefit from intangible assets, a source of economic moat, in the form of intellectual property, but may also reap the rewards from investment in innovation. Not only do many of these companies benefit from long-term patents on existing drugs, their research and development efforts to release new drugs can help offset margin pressures on existing drugs when patents expire and generic versions enter the market. 

“Innovation is the central building block for the strong economic moats in the drug and biotechnology industry, supporting drug pricing power and launch trajectories. However, drug sales fall significantly following patent expirations, making the continuous cycle of new drugs essential to the industry’s economic moats,” stated Conover and Andersen. 

They further explained that they believe wide moat drug company pipelines are positioned to support 5% annual sales growth, helping to offset upcoming patent losses and further reaffirming the companies’ moats.

Pharmaceutical Moat Stocks with Strong Pipelines and Attractive Valuation

Morningstar Analyst Research

Merck & Co. (MRK)
Price/Fair Value: 0.80

Merck’s oncology portfolio (led by Keytruda) and diversification with strong vaccine and animal health units support strong long-term growth potential despite new competition.

Patents, economies of scale and a powerful intellectual base buoy Merck's business and keep it well shielded from the competition. As the bedrock of Merck's wide moat, patent protection should continue to keep competitors at bay while the company strives to introduce the next generation of drugs. Further, the company's enormous cash flows support a powerful salesforce that not only sells currently marketed drugs, but also serves as a deterrent for developing drug companies seeking to launch competing products. The cash flows also put the company in the rare position of being able to support the approximately $800 million in R&D needed on average to bring a new drug to the market.

Bristol-Myers Squibb Co. (BMY)
Price/Fair Value: 0.86

Bristol’s Celgene acquisition brought strong Revlimid cash flows and a late-stage pipeline launching in 2020-21 to counter Opdivo’s lung cancer disappointments and Bristol’s thinner pipeline.

Based on a wide lineup of patent-protected drugs, an entrenched salesforce and economies of scale, Bristol holds a wide economic moat. The patent protection allows the firm to price its drugs at levels that translate into superior returns on invested capital compared with its cost (particularly in cancer drugs, an area of focus for Bristol). The patents also provide Bristol with ample time to bring forward the next generation of new drugs. Additionally, several of Bristol's currently marketed drugs are biologics, which create additional hurdles for generic firms, as the cost of developing and marketing biosimilars is much higher than for typical generic small molecules.

Pfizer Inc. (PFE)
Price/Fair Value: 0.91

Pfizer’s immunology pipeline, led by atopic dermatitis drug abrocitinib along with an established and innovative vaccine platform, supports steady growth.

Patents, economies of scale and a powerful distribution network support Pfizer’s wide moat. Pfizer’s patent-protected drugs carry strong pricing power that enables the firm to generate returns on invested capital in excess of its cost of capital. The patents give the company time to develop the next generation of drugs before generic competition arises. Additionally, while Pfizer holds a diversified product portfolio, there is some product concentration, with the company’s largest product, Prevnar, representing just over 10% of total sales. However, we don't expect typical generic competition for the vaccine, due to complex manufacturing and relatively low prices for the product. We expect new products will mitigate the eventual generic competition of other key drugs. Also, Pfizer’s operating structure allows for cost-cutting following patent losses to reduce the margin pressure from lost high-margin drug sales.


Source: Morningstar Equity Research. Price/Fair Values as of July 31, 2020. Past performance is no guarantee of future results. For illustrative purposes only. Not a recommendation to buy or sell any security. Visit vaneck.com/moat to view daily fund and index holdings.

Executive Order Not Viewed as Major Impediment

President Donald Trump signed several executive orders on July 24, 2020 targeting drug prices, which made for headlines, but Morningstar analysts see the orders creating only modest pricing headwinds and slightly higher uncertainty for drug firms. In short, it is not expected that the orders will significantly affect Morningstar’s fair value estimates or economic moat ratings.

One order allows the import of drugs from Canada in an attempt to undercut U.S. pricing, which, according to Morningstar, is close to double that of international prices. However, two similar legislative attempts to enact the same pricing pressure failed previously at implementation due to safety concerns. A second order targeted drug rebates within the supply chain, but Morningstar believes it is unclear how eliminating drug rebates would affect net drug prices in the current complex system. Lastly, Morningstar does not believe the third order providing for insulin and epinephrine discounts will significantly impact drug companies.

Other proposals and potential orders have been floated that may impact drug companies, but uncertainty remains. 

VanEck Vectors Morningstar Wide ETF (MOAT) seeks to replicate as closely as possible, before fees and expenses the price and yield performance of the Morningstar Wide Moat Focus Index.

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Important Disclosures 

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.

This commentary is not intended as a recommendation to buy or to sell any of the sectors or securities mentioned herein. Holdings will vary for the MOAT ETF and its corresponding Index. For a complete list of holdings in the ETF, please click here: https://www.vaneck.com/etf/equity/moat/holdings/.

An investor cannot invest directly in an index. Returns reflect past performance and do not guarantee future results. Results reflect the reinvestment of dividends and capital gains, if any. Certain indices may take into account withholding taxes. Index returns do not represent Fund returns. The Index does not charge management fees or brokerage expenses, nor does the Index lend securities, and no revenues from securities lending were added to the performance shown. 

Fair value estimate: the Morningstar analyst's estimate of what a stock is worth.

Price/Fair Value: ratio of a stock's trading price to its fair value estimate.

The Morningstar® Wide Moat Focus IndexSM was created and is maintained by Morningstar, Inc. Morningstar, Inc. does not sponsor, endorse, issue, sell, or promote the VanEck Vectors Morningstar Wide Moat ETF and bears no liability with respect to that ETF or any security. Morningstar® is a registered trademark of Morningstar, Inc. Morningstar® Wide Moat Focus IndexSM is a service mark of Morningstar, Inc.

The Morningstar® Wide Moat Focus IndexSM consists of U.S. companies identified as having sustainable, competitive advantages and whose stocks are attractively priced, according to Morningstar.

Effective June 20, 2016, Morningstar implemented several changes to the Morningstar Wide Moat Focus Index construction rules. Among other changes, the index increased its constituent count from 20 stocks to at least 40 stocks and modified its rebalance and reconstitution methodology. These changes may result in more diversified exposure, lower turnover and longer holding periods for index constituents than under the rules in effect prior to this date.

The S&P 500® Index is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Van Eck Associates Corporation. Copyright ©2020 S&P Dow Jones Indices LLC, a division of S&P Global, Inc., and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of S&P Global and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.

An investment in the VanEck Vectors Morningstar Wide Moat ETF (MOAT®) may be subject to risks which include, among others, investing in equity securities, consumer discretionary, financials, health care, industrials and information technology sectors, medium-capitalization companies, market, operational, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount risk and liquidity of fund shares, non-diversified, and concentration risks, which may make these investments volatile in price or difficult to trade. Medium-capitalization companies may be subject to elevated risks.

Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider a Fund's investment objective, risks, charges and expenses carefully before investing. To obtain a prospectus and summary prospectus for VanEck Funds and VanEck Vectors ETFs, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus for VanEck Funds and VanEck Vectors ETFs carefully before investing.

Important Disclosures 

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.

This commentary is not intended as a recommendation to buy or to sell any of the sectors or securities mentioned herein. Holdings will vary for the MOAT ETF and its corresponding Index. For a complete list of holdings in the ETF, please click here: https://www.vaneck.com/etf/equity/moat/holdings/.

An investor cannot invest directly in an index. Returns reflect past performance and do not guarantee future results. Results reflect the reinvestment of dividends and capital gains, if any. Certain indices may take into account withholding taxes. Index returns do not represent Fund returns. The Index does not charge management fees or brokerage expenses, nor does the Index lend securities, and no revenues from securities lending were added to the performance shown. 

Fair value estimate: the Morningstar analyst's estimate of what a stock is worth.

Price/Fair Value: ratio of a stock's trading price to its fair value estimate.

The Morningstar® Wide Moat Focus IndexSM was created and is maintained by Morningstar, Inc. Morningstar, Inc. does not sponsor, endorse, issue, sell, or promote the VanEck Vectors Morningstar Wide Moat ETF and bears no liability with respect to that ETF or any security. Morningstar® is a registered trademark of Morningstar, Inc. Morningstar® Wide Moat Focus IndexSM is a service mark of Morningstar, Inc.

The Morningstar® Wide Moat Focus IndexSM consists of U.S. companies identified as having sustainable, competitive advantages and whose stocks are attractively priced, according to Morningstar.

Effective June 20, 2016, Morningstar implemented several changes to the Morningstar Wide Moat Focus Index construction rules. Among other changes, the index increased its constituent count from 20 stocks to at least 40 stocks and modified its rebalance and reconstitution methodology. These changes may result in more diversified exposure, lower turnover and longer holding periods for index constituents than under the rules in effect prior to this date.

The S&P 500® Index is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Van Eck Associates Corporation. Copyright ©2020 S&P Dow Jones Indices LLC, a division of S&P Global, Inc., and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of S&P Global and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.

An investment in the VanEck Vectors Morningstar Wide Moat ETF (MOAT®) may be subject to risks which include, among others, investing in equity securities, consumer discretionary, financials, health care, industrials and information technology sectors, medium-capitalization companies, market, operational, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount risk and liquidity of fund shares, non-diversified, and concentration risks, which may make these investments volatile in price or difficult to trade. Medium-capitalization companies may be subject to elevated risks.

Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider a Fund's investment objective, risks, charges and expenses carefully before investing. To obtain a prospectus and summary prospectus for VanEck Funds and VanEck Vectors ETFs, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus for VanEck Funds and VanEck Vectors ETFs carefully before investing.