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 HUTCHMED (China) Limited (NASDAQ:HCM) 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.

A laboratory filled with vials and test tubes showing the high-tech drug development process.

HUTCHMED (China) Limited (NASDAQ:HCM)

Short Interest as % of  Shares Outstanding: 0.28%

Number of Hedge Fund Investors In Q2 2024: 7

HUTCHMED (China) Limited (NASDAQ:HCM) is a Hong Kong based pharma company that focuses primarily on developing treatments for cancer and tumors. This means that it is an R&D intensive business that has to wait for the revenue to flow in - a trend that's visible in HUTCHMED (China) Limited (NASDAQ:HCM)'s financial performance. Between the years 2020 to 2023, 2023 was the only one where HUTCHMED (China) Limited (NASDAQ:HCM) generated a profit which sat at $100.7 million. This profit was accompanied by a strong 96.7% annual growth in the firm's revenue. Key to HUTCHMED (China) Limited (NASDAQ:HCM)'s growth profile has been its FRUZAQLA drug for colon cancer and its partnership with Japanese cancer drug firm Takeda. Takeda has agreed to pay HUTCHMED (China) Limited (NASDAQ:HCM) a total of $400 million in upfront payments for FRUZAQLA, and the $280 million payout out of this in 2023 drove the firm's revenue. Future payments could mean tailwinds for the stock, while any regulatory hurdles or untoward news particularly for the colon cancer drug could spell trouble.

Overall HCM ranks 5th on our list of the cheap pharmaceutical stocks to buy according to short sellers. While we acknowledge the potential of HCM 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 HCM 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.