Buy Bayer for value

Bayer's shares have moved in lockstep with the Dax index and are a quarter below their pre-July peak. That simply reflects Bayer's business model, which draws a third of its sales from industrial chemicals and materials, sectors that are notoriously sensitive to the ups and downs of the business cycle. During the past two years, the cycle has favoured Bayer with big upswings in industrial activity creating demand for its specialist materials (its material sciences division saw sales leap by 50 per cent in 2010, for instance). Most likely, the division will struggle to match that level of performance if economic activity slows this year, which is why investors have been selling its shares. However, it can make sense to buy the shares when the cycle is heading into its weakest phase. Investors with the fortitude to buy can wait for the upswing that will prompt a re-rating.

Aside from offering that trading opportunity, the fundamentals of Bayer look encouraging. Bayer is more diversified than specialised most chemicals or pharmaceuticals groups. It is a world-leader, alongside Monsanto, in crop sciences, a growth area (if you'll pardon the pun) that contributes a third of its cash profits and is the group's single most profitable segment. The healthcare division has been hit by competition from generics suppliers and various legal disputes, which contributed to the company booking a €1.7bn exceptional charge last year. However, Bayer's drug development pipeline has shown signs of life with promising data for its cardiac arrhythmia drug, Xarelto, which analysts at the investment bank arm of RBS estimate could be worth €1.4bn in sales by 2015 if it can get marketing approval.

Bayer's balance sheet also looks solid. Net debt rose slightly to €7.4bn in the first half of 2011, but, with stable levels of working capital, analysts reckon net debt will halve by 2013. That leaves Bayer with enough fire-power to bulk up its business via acquisitions.

In particular, the animal health division could be expanded if other big players exit the market. Animal health is a particularly resilient activity and it returned to its long-term growth rates quickly after the recession of 2008-09. According to analysts at Credit Suisse, Bayer has 7 per cent of a total global market of $20bn. Adding scale to that operation is possible now that Pfizer, the world's biggest animal health company with 19 per cent of the market, announced it is examining its options for the division. Pfizer needs cash to fund acquisitions to head off a drop in sales when its major drugs go off-patent. So Bayer could be well-placed to benefit as anti-trust concerns would rule out larger players, such as Merck-Serono, from bidding.

Diversity can, of course, be a weakness as well as a strength and Bayer has illustrated this paradox in the past 10 years by booking a number of varied exceptional charges. In 2003, it wrote-down profits by €2.2bn after hiving off its polymers business, while last year's surprise fourth quarter loss was because of legal entanglements stemming from genetically-modified rice. So investors will need to be wary of the "conglomerate" discount that can afflicts the likes of Bayer. Exposure to the business cycle also partly undermines the defensiveness of Bayer's pharmaceuticals side, so expect its shares to be more volatile than those of other pharma giants.