(MONEY Magazine) – Wouldn't you know it. The Wall Street intelligentsia starts touting pharmaceutical stocks as a safe haven for tech-wrecked investors, and almost immediately big pharma gets into a fender bender of its own. With a host of blockbuster drugs about to lose patent protection and an avalanche of bad news on the political and regulatory fronts, the world's dozen largest drug stocks fell an average of 15% through the first 6 1/2 months of 2001. Total cost to shareholders: $180 billion.

Rough stuff--but with a silver lining. While that slide reflects some serious short-term concerns, we also think it makes the long-term case for drug stocks that much more compelling. It allows investors to buy into quality franchises at lower prices.

First, though, we need to understand their current woes. Many investors were lured by drug stocks' hefty gains in 2000--29% for the Amex pharmaceuticals index--and by expert predictions of outsize returns even in tough economic times. J.P. Morgan equity strategist Doug Cliggott and others put forth the argument that investors would pay more for pharma's recessionproof 8%- to 12%-a-year earnings growth when other industries were in the dumps. It hasn't worked out that way in 2001, but in fairness to Cliggott, pharma's current problems have little, if anything, to do with a weakening economy. It's not Alan Greenspan's fault that eight blockbuster drugs--including Claritin and Prozac--will go off patent by the end of 2002, costing the industry billions in annual sales. Nor is the economy to blame for the Food and Drug Administration's more deliberate approach to approving new drugs or for Congress considering a prescription-drug benefit for senior citizens on Medicare. Analysts are particularly worried about the Medicare proposal, since adding a drug benefit could make the federal government responsible for buying 52% of all domestically sold drugs. In that scenario the result would be de facto price controls, as the government would have tremendous leverage to negotiate steep discounts with drugmakers.

BAD REACTIONS

Of course, investors are likely overreacting to these threats. Congress' bark is usually worse than its bite when it comes to health-care reform. And as much as analysts fret about patent expirations and big pharma's uninspiring drug pipeline, the industry has heard such complaints before and has found ways to restock its pipeline--either through path-breaking research and development or by licensing new drugs from biotech upstarts that lack the marketing muscle to sell their own drugs effectively.

If you think the message sounds decidedly mixed, you're not alone. Ace health-care investor Sam Isaly, who's been managing Eaton Vance Worldwide Health Sciences Fund since 1989, calls today's environment "about as indecipherable a situation as I've ever seen."

Looking beyond today's confusion, however, Isaly is siding with the bulls, convinced that a graying U.S. populace coupled with scientific breakthroughs in genomics and cancer treatment has set the stage for a health-care golden age. "If the past decade belonged to the technology investors, I think this next decade will belong to us," Isaly says.

We won't go that far, but there's no question that investors willing to be a little contrarian can find a huge opportunity in drug, biotechnology and medical device stocks.

Purely by the numbers, the sector has rarely been more appealing. With the oldest baby boomers turning 60 later this decade, the federal Health Care Financing Administration now expects annual prescription-drug expenditures to reach $366 billion by 2010, up from $117 billion last year. That's a growth rate more than twice what's projected for the gross domestic product. (For a look at how some consumers are beating the high cost of prescription drugs, see the story on page 118.)

POTENT PROFITS

The statistical case for pharma doesn't end there. Over the past five years, the drug component of Standard & Poor's 500 has boasted an average price-to-earnings multiple 42% higher than that of the broader index. Today the premium is only 24%, despite the fact that S&P pharmaceutical stocks are on pace to boost earnings 13% this year vs. a decline of 12% for the overall index.

Another bit of statistical history working in the sector's favor is its stellar--albeit perplexing--second-half performance record. In six out of the past seven years, the S&P 500's pharmaceutical segment has outperformed the overall index from July through December. During those six years, pharma's average margin of victory was an eye-popping 12 percentage points. Since this is not an inherently seasonal business, there's no obvious reason why pharmaceuticals should be such strong second-half stocks--though Isaly has a pretty good theory: "You've got all your scientific conferences in the fall, and the companies manage the news flow almost as well as they do their earnings."

LOWER PRICES, MORE PILLS?

In addition to the quantitative case, there's a qualitative one to be made as well. The stock market's concerns about a tougher FDA and the potential profit squeeze from a Medicare prescription-drug benefit appear overblown. In the unlikely event that Congress and the President ever agree on legislation, it's quite possible that increased drug consumption by seniors could offset the effect of lower prices, according to health-care consultant Joseph Palo, a partner at PriceWaterhouseCoopers. Moreover, while there's little doubt that the FDA has slowed its approval process--okaying nine new drugs in 2001 vs. 16 at this time last year, according to American Health Line--the slowdown may not be permanent. While some believe that the FDA is cracking down after being embarrassed by last year's withdrawals of Pfizer's diabetes drug Rezulin and GlaxoSmithKline's irritable-bowel-syndrome treatment Lotronex, a less ominous explanation can be found. The agency has been without a leader since commissioner Jane Henney resigned in January. Until President Bush nominates her successor, the FDA will be loath to approve any drug that is the least bit controversial. "Without someone up there setting policy, it's going to be a bit of a challenge," says Matthew Weinberg, a Washingon, D.C. health-care consultant and lobbyist.

CHOOSING CAREFULLY

All in all, we think that this makes drug and high-tech health-care stocks worth owning--and now is a good time for long-term investors to get in, since much of the sector is trading at discounted prices. The question is which stocks and funds to buy. Not long ago, investors didn't have to be particularly discerning. Even poorly run companies boasted market-beating stocks, as consumers and regulators accepted aggressive pricing. Today, with managed care putting the brakes on rising prescription costs, the economics of the industry strongly favor blockbuster drugs and the companies that can market them most effectively. "You've got a clearer distinction now between winners and losers, and accordingly more investment risk," says Richard Evans, a drug stock analyst with Alliance Capital subsidiary Sanford C. Bernstein.

After running the numbers and grilling the experts, we settled on nine stocks in four areas--pharmaceuticals, biotech, generics and devices--plus four mutual funds. In the pages that follow, we spell out the risks and opportunities for these sectors--and why we believe our picks are best positioned to exploit burgeoning demand for cutting-edge health care. Our selections range from value plays like Waters Corp., a maker of high-tech equipment used in the fast-growing field of protein analysis whose stock has sunk 70% this year, to traditional blue chips like Pfizer and Abbott Laboratories. One name you won't find on our list is Johnson & Johnson, a stock we profiled in our August issue. We still believe that J&J's combination of a stable consumer-goods business with a topnotch pharma operation makes it the "ultimate buy-and-hold stock." But for this story we chose to focus on purer health-care outfits. Now, on to the sectors.

--J.B.