My favorite drug company, Valeant Pharmaceutical (NYSE:BHC), has returned 72% annually over the past five years. That's more than three times the average return of the industry. And it's not the result of a blockbuster drug developed by the company. In fact, Valeant barely does any investment research and development.
The traditional approach: Big Pharma
Numerous academic studies have shown that investments in research and development generate high-returns. And the traditional model in pharmaceuticals has been to spend heavily to research, develop, and gain regulatory approval for new compounds. Obviously, not every research dollar generates a return, but by maintaining a portfolio of research projects, hopefully a few big winners will more than justify the cost of the total portfolio. Big Pharma companies such as Pfizer (NYSE:PFE) and Merck (NYSE:MRK) tend to follow this approach -- spending lots on research each year. Last year, Pfizer spent $7 billion (12.5% of revenue) on research. Merck spent nearly $8 billion (17% of revenue).
So what's the problem with this approach? Unfortunately, actually developing a drug is very difficult and expensive. And the average rate of return on research spending isn't very high -- 7.2% based on a study by Deloitte. That rate of return barely justifies the investment, and it's probably one of the many reasons we've seen large pharma companies increasingly rely on acquisitions to bolster their product pipelines.
The radical approach: Valeant
Valeant does invest in research, but only a relatively small amount. According to management, the returns on investing in research simply aren't high enough in most cases. Management believes that it can get a better return by purchasing proven drugs or companies with existing product portfolio. It's a lot less risky, and the returns, especially if acquisitions are made judiciously, are a lot higher than investing in drug development. Internally, Valeant targets a cash-on-cash return of 20% on its acquisitions. And generally, the company has achieved that target.
Obviously, some people -- scientists and researchers, especially -- find this approach abhorrent. But, it's worked out very well for shareholders. Since CEO Michael Pearson joined the company five years ago, the stock is up 10-fold.
Foolish bottom line
Conventional methods are bound to yield mediocre results. Valeant's acquisition-based strategy doesn't conform to industry norms -- it's actually a fairly radical departure. But its unconventional approach has yielded outstanding results.