Portland, Ore. (CNN/Money) -
Are the "big pharmas" finally ready to move up from the back of the pack?
The group of large pharmaceutical stocks mostly missed out on most of the market's rebound in 2003, with shares on average gaining 12 percent, as measured by the American Stock Exchange pharmaceutical index. The Standard & Poor's 500 stock index, meanwhile, gained 26 percent, and the Nasdaq ran 40 percent.
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Now, however, big pharma stocks may get another chance.
"The market is in a rotational phase toward the more stable growth companies -- and that would include the big pharmaceuticals," says Donald Gher, portfolio manager for Coldstream Capital, a money management firm in Seattle. (Gher owns Pfizer and Merck in his fund.)
Indeed, many value investors are eyeing the sector's growth prospects (11 percent for 2004, according to a recent report by Credit Suisse/First Boston), and relatively low P/Es (many trade around 15 times expected earnings). Dividend yields are above average too.
Longer term, there's an aging world population that almost seems to guarantee steady demand for drugs.
If there is a slowdown in the performance of more speculative techs and telecoms, the bulls say, investors would start seeking the relative safety of drug company stocks.
Solid growth, below-average P/Es -- just when are these stocks supposed to start moving?
Living with big pharma's "issues"
Critics say the sector isn't as safe and reliable as it once was.
"There's a lot of instability involved with these stocks, and if you can't afford to spend all your time watching them, you should probably leave them alone," says a Miami investor who didn't want to be identified. "There are so many pressure points: the politics, pricing, generics. I'm just not comfortable with stocks that turn on a dime every time something happens."
Consider some of the biggest issues that are difficult for investors to keep on top of:
- Patent Expirations When patents on therapies expire, it opens the door to competition from generic drug makers. Several industry analysts agreed that generics almost immediately take 50 percent of a branded drug's market share, On Thursday, Bristol-Myers Squibb warned that 2004 earnings would be below forecasts for exactly that reason, and its stock got clipped nearly 4 percent (see more). Others are at risk: Schering-Plough is still fighting to overcome the Claritan patent expiration. Merck faces the expiration of Zocor in 2006.
- New Product Flops Merck was the leader is this dubious category last year, as it cancelled four drugs, two of which had been touted as blockbusters.
- Thinning Pipelines. Merck, Schering-Plough and Wyeth are the pharmas most often cited as facing low pipeline production for the next few years.
- Government Regulation Many analysts, including A.G. Edwards' Al Rauch and Standard & Poor's, think that Congressional attempts to reform Medicare, at least this time, should boost industry profits since the drug benefit will spur sales. Nevertheless, there still is uncertainty about how the government will proceed, and that could continue to weigh on shares.
I'll take the combination plate
But, by focusing on the problems, investors lose sight of the big picture, argues one buy-side analyst who requested anonymity. "We are talking about big worldwide companies with amazing numbers of new products under development. These companies have the marketing clout to sell anything. You can't underestimate them."
Unfortunately, even analysts and portfolio managers don't agree on which ones the average investor should choose.
As a general rule, they're looking for those with the most product in the pipeline, best growth rates, and most reasonable P/Es.
Pfizer is often cited by analysts and portfolio managers as safe play among the sector stocks. Though the stock trailed the market by about 10 points in 2003, it was one of the group's best performers.
Analyst Rauch of A.G. Edwards likes Eli Lilly, and more controversially, Schering-Plough.
Schering was one of the worst performers in the group in 2003, losing 19 percent. The company lost a battle to protect its Claritan patent through 2004, and last year the first of the generic versions of Claritan appeared on the market. In addition, some analysts say Schering has little in its product pipeline to replace Claritan for at least several years. And the company is still smarting from a government fine of $500 million levied in 2002, the result of failure to comply with quality standards at two of itws manufacturing facilities.
But Rauch thinks much of that bad news is in the stock, and that it can benefit from a partnership with Merck to produce a combination cholesterol drug.
Lilly has a strong product lineup and a strong pipeline, think Rauch. Its already-established products include Zyphrexa (for schizophrenia) and Gernzar (anti-cancer therapy), and soon to come are Cialis (erectile dysfunction) and Strattera (hyperactivity). Meanwhile, the anti-depressant drug Cymbalta is undergoing the FDA approval process.
Even so, other analysts and portfolio managers think Lilly's P/E, at 24, is too high.
If you're worried about your ability to suss through all these issues, owning a basket of drug stocks is a good option, and one of the most cost-effective ways to do that is with a mutual fund or an exchange traded fund.
Vanguard's Health Care fund boasts one of the best long-term records of any health care fund, and is on MONEY Magazine's MONEY 100 list of best funds.
Another option is the Pharmaceutical HOLDRS Trust (PPH: Research, Estimates), traded on the American Stock Exchange, which is a fund composed of about 20 health care stocks. The big drug stocks are all there, and the fund gained less than 10 percent in 2003.
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