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Investing after Pfizer's flop - 3 strategies

Despite the failure of Pfizer's new drug, there are still attractive strategies for health care investing - from sector funds to J&J.

By Michael Sivy, Money Magazine editor-at-large

NEW YORK (Money) -- Pfizer's decision to suspend tests of its latest drug for the treatment of high cholesterol underscores the key problem facing most large pharmaceutical companies. Once a drugmaker has reached a certain size, it's an enormous challenge to generate new blockbusters fast enough to maintain a high growth rate.

And there's another hurdle to get over. A number of billion-dollar drugs will lose patent protection during the next few years. And the companies that produce such brand-name products often don't have enough drugs in the pipeline to replace them.

Pfizer, in particular, is facing the loss of patent protection for Lipitor, a cholesterol treatment that is the world's best-selling drug with revenues of more than $12 billion a year.

Pfizer (Charts) has already announced that it would cut one-fifth of its U.S. sales force to lower costs. But the fact is, it and other industry leaders will only be able to grow earnings if they can find enough new products.

Does that mean that health-care investing is finished? Not at all. The basic case remains as compelling as ever.

The Baby Boom generation is retiring and will soon be suffering from chronic ailments that are best treated with drugs. In addition, even the most expensive pharmaceuticals are a bargain if they prevent or forestall the need for more expensive hospital treatment.

The pharmaceutical industry is also one of the world's most important growth industries - and one that the U.S. dominates.

There's no doubt that there's plenty of money to be made in the drug business. The question is what the best investing approach may be.

Three smart strategies

Obviously, large pharmaceutical companies will have to concentrate on controlling costs and trying to boost the success rate of their research ventures.

But they also need to diversify their product mixes as broadly as possible and acquire successful mid-size drugs as well as blockbusters.

That means that pharmaceutical giants will be likely to buy promising products. By merging with each other or acquiring smaller firms, a company can ensure that its sales force will have a bigger selection of products to sell.

This outlook suggests that investors might not want to pick individual stocks but rather invest in the industry as a whole. It's clear that there's money to be made and that the industry will eventually figure out how to be successful again. If you invest in the entire sector, you won't have to worry which companies turn out to be the biggest winners.

Two big families of exchange-traded funds offer pharmaceutical ETFs. Among Spiders, there's SPDR Pharmaceuticals (XPH (Charts). And among iShares, there's Dow Jones U.S. Pharmaceuticals (IHE (Charts). Both ETFs are only about six months old and so far have assets of less than $100 million. But they've been performing well.

A second strategy is to invest in generic drug makers. These companies produce copies of popular drugs that have lost their patent protection. Because generics are much cheaper than brand-name products, they will gain market share as more drugs come off patent. In addition, analysts expect the Democratic Congress to promote the use of generics to help hold down growth in health-care costs.

The world's largest generic pharmaceutical maker is Teva Pharmaceutical (Charts), based in Israel. But even though Teva is projected to have strong growth over the long term, earnings are projected to decline slightly next year and the stock doesn't appear to be timely.

An alternative to Teva is Barr Pharmaceuticals (Charts), a U.S. generics producer with annual sales of more than $1 billion. The stock is widely recommended by analysts. And at a current $51, the shares trade at just over 15 times earnings for the coming year. Compound annual growth is projected at more than 15 percent.

If you want to stick with large, established companies, such as those included in the Sivy 70, a third strategy is to buy a widely diversified company like Johnson & Johnson. In fact, superstar investor Warren Buffett was loading up on J&J (Charts) last year at prices not far below today's.

Not only is J&J one of the most diversified health-care companies, with a wide assortment of consumer products and professional items as well as brand-name drugs, but the company's track record is extremely solid. In fact, Johnson & Johnson has raised its dividend for 44 years in a row.

Growth over the next five years is projected to average at least 10 percent annually. And at a current $66.28, J&J yields a healthy 2.3 percent and trades at 16.3 times projected earnings for the coming year.

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.