Indian pharma shares are making a remarkable recovery. In under a fortnight, the BSE Healthcare index has gained by 12.6%. The vertical nature of this increase raises the question of investors getting ahead of themselves. Valuations are not cheap with the index at a price-to-earnings multiple of 32 times trailing 12-month earnings.

A few companies have certainly seen some positive triggers emerge but that’s not enough reason to justify all-round optimism. Nearly half the constituents of the healthcare index have seen their values rise by more than 10% since 5 June, while a fourth have seen their prices rise by over 20%. Also, in the list of top 10 gainers in the healthcare index, there is not a single large-cap stock and most are small-cap ones.

Disparate events are driving this optimism. For instance, recently, Sun Pharmaceutical Industries Ltd finally got US FDA (Food and Drug Administration) clearance for its Halol plant. Other leading companies have gained because of drug approvals. Taking specific instances to form a collective view that the sector has turned around could be a mistake.

On the US regulatory front, there remain unresolved issues on the compliance front, including for big companies. Also in the US market, stiff competition and price erosion remain a problem. Companies have said they expect pricing pressure to slow down in FY19. Investors are also hoping that revenues from generic launches make up for price erosion. All this will play out in the coming quarters.

The US government and regulators too are keen on lower drug prices, not just for innovator company drugs but also for generic drugs themselves to become cheaper. The quicker pace of US FDA approval is good news but could also result in more competition among generic companies.

The big Indian companies want to sell more complex generic drugs and speciality drugs in future, to escape these pressures. Initially, that means higher investments in research and in setting up marketing infrastructure even as sales growth is slowing, which can affect margins. Companies have already warned investors of this.

Growing protectionism in the US is another threat though extending it to pharmaceuticals could increase the cost of medicines. Since India is one of the key exporters to the US, any specific barriers could increase the cost of doing business.

On the domestic market, growth has stabilized. April saw sales grow by 7.8% and May by 10.8%, according to market research agency AIOCD Awacs. This is the first month after April 2017 that growth has crossed 10%.

While domestic demand appears to be stabilizing, there is pressure to lower drug prices even in the domestic market. When the Prime Minister himself talks about lowering drug costs in speeches, investors should be prepared for policy changes. A pet theme has been to substitute non-branded generics with branded generics to lower medicine costs. So far, its spread has been limited but a concerted effort to increase adoption through policy changes remains a risk.

These are some of the main challenges that can play out in the next year or two. Some stocks may surely emerge as winners in this period but the current rally presumes most will. Investors should not get carried away by the tide of rising sentiment in favour of pharmaceutical stocks.

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