(FORTUNE Magazine) – Science geeks may debate the exact beginning of the New Millennium. Was it Jan. 1, 2000, or a year later, in 2001? Drug company investors, though, have no doubt when the new era commenced. On the first day of trading in January 2001, the American Stock Exchange pharmaceutical index embarked on a slow and steady downward creep after hitting its all-time high just days before. In the preceding five years, the index had logged an unrelenting climb of 367%. Since that day in 2001, the stocks have lost roughly a third of their value. Investors haven't looked at drug companies in the same way since.

For years, after all, investing in this sector was hardly a science. Historically speaking, investors could always take their pick from among the Big Pharma firms and be assured of handsome returns. In the past decade alone that same Amex pharmaceutical index trounced the broader market, climbing 318%, compared with the S&P's rise of 142%. But even with the market in rebound mode this year, drug stocks have lagged. Since May the S&P has jumped 26%, while the drug index has risen only 6%.

So why are investors saying no to drugs? While the recession and the long slide in the broader financial markets haven't helped matters, the central issue is an epidemic of profit pressures that has hobbled the industry's strongest companies. In recent years, even as the average R&D cost of bringing a new drug to market rose to more than $800 million, drugmakers have confronted patent expirations and greater competition from generic manufacturers. Many product pipelines are virtually tapped out. And while companies are pouring money into new genetic research methods, a raft of new drugs based on the technology isn't expected to materialize until the end of this decade. At the same time, the general public's regard for drug companies is on the decline. Consumers and lawmakers are demanding new innovative drugs while pressuring the industry to hold down prices.

All of which means that, for savvy investors, there's great opportunity in pharma right now. Why? Drugmakers' stocks now trade at an average price-to-earnings ratio of 9.3, roughly half the value of the overall market. It's very likely that the industry's woes are already factored into share prices. And the fact is, it's not all gloom and doom in the drug business. The overall economy is on the mend, after all. The demographics of the baby boom are certainly working in the industry's favor. And although drugs are not cheap, they remain the least expensive means to treat chronic ailments.

More important, the drugmakers' political problems have begun to subside. It was no small victory that Big Pharma narrowly avoided the threat of government price controls in the Medicare reform law enacted last month. The new prescription-drug benefit program will set aside $400 billion over ten years to subsidize up to 80% of elderly Americans' drug bills. Indeed, the program, which begins in 2006, is expected to boost industry sales by some 9%, or $13 billion a year, according to Goldman Sachs pharmaceutical analyst James Kelly. And that's not all. The industry's well-paid corps of lobbyists were able to gain new protections against legal importation of cheap foreign drugs.

But to take advantage of a new surge in the sector's fortunes, investors will need to look beyond the household names and consider the entire landscape of medicine makers--including generic manufacturers, small specialty-drug firms, and large biotechs--to find the companies earning the best returns on their investments. Particularly since drug companies are responding to the new industry realities by employing radically different survival strategies. "R&D productivity is a company-by-company story," says Standard & Poor's analyst Herman Saftlas. "Since the industry is not succeeding where it once had, the basket approach makes sense, placing bets throughout the entire drug-development universe."

To help implement that strategy, we talked to industry analysts and veteran investors, examined company pipelines, and identified five drugmakers with a healthy opportunity to reward shareholders over the next few years.

Drug colossus Pfizer (PFE, $34) looms large over its competitors in every way. In 2003, Pfizer's estimated net income growth of 28% (on revenues of $45 billion) was powered by eight medicines, each of which was the leader in its therapeutic class. The completion of its merger with Pharmacia gave the company another blockbuster in arthritis medicine, Celebrex. Each of these drugs generated $1 billion or more in revenue. The biggest of them, cholesterol-fighting Lipitor, is projected to become the world's first drug to achieve $10 billion in annual sales by 2005.

Pfizer's focus in 2004 is to be more productive in its hunt for new drugs. "Productivity doesn't have to be encumbered by scale," says Pfizer CFO David Shedlarz, who insists that R&D is less of a risky venture for a company of Pfizer's size. Indeed, the company has $13 billion in operating cash flow, and that figure should rise to $18 billion in 2004.

Pfizer also has a strong late-stage pipeline. The company says it will file patent applications for 20 new chemical compounds by 2006. In October, Pfizer received the FDA go-ahead to market Inspra, a treatment for heart failure. Meanwhile, Pfizer shares are currently trading near a five-year P/E low of 18.

Traditional pharma powerhouse Eli Lilly (LLY, $70) suffered a big blow in mid-2001 when the Indianapolis company's top-selling antidepressant, Prozac, lost its patent protection sooner than expected. Prozac accounted for roughly 30% of Lilly's sales, and with generic competitors entering the market, sales of the $2.6-billion-a-year drug fell by 61% in 2002. That, combined with some manufacturing problems, caused Lilly's net income to dip in 2002 by 3%, to $2.7 billion. Since the Prozac news first hit, shares of Lilly have tumbled 15%.

While investors were punishing the company, however, Lilly's research department was preparing to answer back. Between 1997 and 2002, Lilly management poured 20% of the company's $11 billion in revenues into research, compared with the industry average of 13%. Though money doesn't always buy new drugs, Lilly's investment has paid off. Earlier this year, Strattera, a new Lilly drug for attention-deficit/hyperactivity disorder, achieved the fastest launch of any neurological drug in history. Doctors wrote one million prescriptions for the drug in its first six months on the market. In the next 24 months, Lilly anticipates gaining FDA approval of and launching four more drugs: impotence treatment Cialis; Symbyax for bipolar disorder; Altima, a lung cancer treatment; and an antidepressant known as Cymbalta. Once the initial costs of launching the drugs are out of the way, Lilly is well positioned to outperform its peers.

In recent years the generic-drug makers have become increasingly aggressive in their legal patent challenges to Big Pharma drugs. No company has been more assertive in the courts than Israel's Teva Pharmaceutical Industries (TEVA, $61). With a portfolio of 160 pills and ointments, the $2.5-billion-a-year company is the world's largest provider of generic prescription drugs. In fact, one in every 15 prescriptions written in the U.S. is for a Teva product. In October, the company logged a year-over-year prescription-growth rate of 10%.

In November, Teva's management achieved a long-held desire to enter the market for generic injectable drugs when it purchased Sicor Inc., of Irvine, Calif. The acquisition adds lucrative anesthesiology and cancer treatments. As a result, UBS Investment Research analyst Steven Valiquette expects Teva to post net income growth of 45% in 2003 and 21% in 2004.

There was once a clear division between the biotech sector and Big Pharma. These days Amgen (AMGN, $59), the world's largest biotech--with a market cap of $74 billion--combines old-line stability with biotech growth prospects. A recent Standard & Poor's industry survey pegged biotech-sector sales growth at 20% in each of the next five years. Thanks to two blockbuster drugs (red-blood-cell booster Epogen and rheumatoid arthritis drug Enbrel), Amgen's 2003 earnings are expected to be $2.5 billion, up 49% over the previous year. The biotech giant is focused on large underexploited markets like cancer and metabolic diseases. One drag on Amgen is the question of whether it will need to acquire other companies to beef up its pipeline. Even so, biotech analyst Jim Reddoch of Friedman Billings Ramsey says, "I'm a believer. Based on the scale of revenues and their rate of growth, they're a compelling growth stock compared with their market-cap peers in Big Pharma."

Unlike Amgen, the majority of biotech companies are still small operations in which it's rare to actually have a drug on the market, let alone a potential blockbuster. Icos (ICOS, $45) has both. In late November the FDA approved the U.S. sale of Cialis, an impotence drug which notoriously lasts not four or five hours, like its competitors Viagra and Levitra, but 36 hours. After developing the drug (dubbed the "weekender" in Europe) on its own, Icos wisely entered a fifty-fifty joint venture with Eli Lilly to provide marketing support. The drug has already gained considerable market share against Viagra in Europe, Australia, and Latin America, where it's been on the market for just under a year. Although Cialis's launch costs came in under projections, Icos won't realize any real gains from the drug until after 2004. The company hopes to follow up with a pneumonia compound and a medicine for urinary disorders, both of which are in Phase II of development. That should keep its stock rising.