Because of the Memorial Day holiday, the next Sivy on Stocks column will be published on Tuesday, June 1.
NEW YORK (CNN/MONEY) -- Judging by current price/earnings ratios, investors think that pharmaceuticals stocks have less growth potential than makers of laundry detergent.
How can this be? It wasn't so long ago that Big Pharma was one of America's top growth businesses and that the stocks carried P/Es of 35 or more.
Moreover, the current environment ought to favor drug stocks, which are classic defensive businesses. Normally, they hold up well when most stocks are pulling back, because the businesses are resistant to mild economic slowdowns and are relatively unaffected by upticks in inflation and rising interest rates.
But instead of ranking at the top of the list for investors seeking safe harbors for their money, drug stocks have lost their glamour factor almost entirely.
Admittedly, the industry faces some problems. The top companies have grown so big that it is hard for them to keep increasing revenues at an above-average rate.
At the same time, many of the most successful companies seem to have run out of innovative product ideas. Pipelines look skimpy -- and that will remain true for at least another couple of years.
In addition, the industry is concerned about the loss of pricing power, because of the re-importation of drugs from Canada and changes in reimbursement rules for Medicare and insurance programs. Moreover, in the background lurks the possibility of new health-care programs that would bring significantly tighter government regulation.
I think that all of these problems are overstated. Moreover, at present prices, I believe that the shares of top drug companies fully discount the bad news.
The big picture
Before I address the drug industry's problems one by one, I think it's key to think about the big picture.
Health-care spending is inevitably going to grow at a faster rate than the overall economy. Drugs are usually the cheapest way to treat chronic medical problems, and soon, retired baby-boomers will develop a host of minor ailments that require drug therapy.
How can regulation change these trends? For political reasons, the United States is never going to embrace European- or Canadian-style socialized medicine. However the problems of inadequate medical care in this country are addressed, it will boil down to subsidizing care for people who are not currently covered.
In other words, reform will only increase the total spending on pharmaceuticals. There may be some restraint on drug prices, but I would bet that drug companies' overall profits will be allowed to increase at an above-average rate.
The bottom line: Companies may make less per pill but end up selling more volume -- and net income will keep going up.
How to play the trend
The consensus pick is still Pfizer (PFE), $35.40 a share, trading at only 15 times next year's projected earnings and offering a 1.9 percent yield. That's a below-average valuation for the biggest and one of the best companies in an industry that will grow faster than the overall economy.
Merck (MRK) is the contrarian play. The company, which dominated the industry for many years, has a shockingly skimpy pipeline. But at $47.43 a share, the stock trades at just over 14 times next year's earnings and yields a whopping 3.1 percent. At a time when good income investments are hard to find, the yield alone will attract some investors. And within a couple of years, the pipeline will look more impressive than it does today.
For investors who want a more aggressive choice, Amgen (AMGN) is reasonably priced relative to its growth prospects. Because the revenue base is much smaller than that of Pfizer or Merck and because Amgen has a much more promising product pipeline for its size, earnings are projected to rise at a 21 percent compound annual rate over the next five years. Even so, at $54.98 a share, the stock is trading at less than 20 times next year's projected results. That's a PEG ratio of less than 1 on a growth stock, which you don't get to see very often.
Michael Sivy is an editor-at-large for MONEY magazine. The Sivy on Stocks column and newsletter is available only to MONEY subscribers and AOL members. Subscribe now and you will also receive access to the Sivy 70 -- our exclusive list of America's Best Stocks -- and coming in June, to Sivy's Guide to Growth. Click here to subscribe to MONEY and to sign-up for the Sivy newsletter.
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