NEW YORK (MONEY Magazine) - Ten years ago, Merck was the drug stock to own. Breakthrough treatments for high cholesterol, hypertension, asthma and osteoporosis earned Merck a reputation as the best drug researcher in the business, not to mention billions in sales.

With a portfolio of blockbusters such as Zocor for cholesterol and Pepcid for heartburn, Merck towered over rival drugmakers in size and stature.

Then Merck just seemed to topple. Four of its biggest drugs lost patent protection in 2000 and 2001, exposing the firm to ferocious competition from makers of generic drugs.

For example, sales of Merck's expired hypertension drug Vasotec, which hit $2.3 billion in 1999, dwindled to $1 billion last year. With its drugs under assault, Merck's earnings growth dropped from 18 percent in 2000 to 8 percent in 2001.

In December, Merck stunned investors by warning that earnings growth will be flat this year -- the stock fell 13 percent in two days. At around $58, it now trades more than 30 percent below its late 2000 high.

Merck's performance looks even flimsier if you consider the success of archrival Pfizer (PFE: Research, Estimates). Just two years ago, Merck (MRK: Research, Estimates) sported a market value of $143 billion vs. $121 billion for Pfizer. Yet Pfizer now boasts a market value of $250 billion and Merck's is still around $145 billion.

Over the past five years, Pfizer's stock has returned a total of 160 percent, while Merck has scraped together a return of just 30 percent.

Why then have savvy stock pickers like the Oakmark fund's Bill Nygren been hungrily eyeing the stock?

To be sure, disgruntled investors have found plenty of reasons to give up on the company. For a start, Merck hoped to ride out the losses from its patent expirations on the backs of five newer blockbusters, including Singulair for asthma and Vioxx for arthritis. But in 2001, sales of Vioxx fell about $900 million short of expectations, crimped by fears that this class of drug may increase the risk of heart attacks.

And last Friday, Merck shares fell more than 5 percent after the drugmaker withdrew its application for FDA approval of Arcoxia, planned as a successor to Vioxx. Merck said it withdrew the application to add information on the drug's potential for use in cases of chronic spinal inflammation. But Wall Street analysts weren't so sure -- the drug was already designed for broad use, and spinal inflammation represents a very small market. (See more)

Another problem, say critics, is that Merck hasn't been aggressive enough in beefing up its drug portfolio through acquisitions or licensing deals. "They've got a highly rated sales force and they needed to get them more [drugs] to sell," says Linda Miller of John Hancock Health Sciences fund.

By acquiring Warner Lambert in 2000, Pfizer got its hands on Lipitor, a prized cholesterol drug with sales of $6.4 billion last year. Meanwhile, Merck has resisted the idea of using major acquisitions to bolster growth. Hemant Shah, an independent industry analyst, gripes: "A merger would have given them consolidation savings, a portion of that to boost earnings and a portion to increase spending on research and marketing."

Merck makes no apologies, though, for focusing on drug making rather than deal making. "We're distinguished by the excellence of our research," boasts CEO Raymond Gilmartin. "Investing in that capability is the best opportunity for us to create shareholder value."

Indeed, while many drug makers slash R&D spending when earnings are weak, Merck pledged in December to hike its R&D budget by $400 million from an already respectable $2.5 billion.

"Merck could have made their numbers had they chosen to hatchet R&D," says Edward Studzinski, an analyst at Oakmark. "I like that they chose to take the hit and focus on R&D rather than image and perception."

And despite all the criticism, Merck's research-driven strategy may yet pay off. Eleven drugs and vaccines are slated to hit the market between 2002 and 2006, including the delayed Arcoxia, and Merck says eight of these products represent new ways of treating disease. This pipeline includes two potential blockbusters: an anti-depressant and a pill for high cholesterol.

"We're beginning a whole new cycle of important product launches," says Gilmartin. The threat from generic drugs seems likely to wane too. After this year, Merck won't be troubled by significant patent expirations until 2006, when Zocor -- now a $6.7 billion-a-year drug -- loses its patent.

A planned spin-off this summer of Merck-Medco, which manages pharmacy benefit plans for employers, also looks like a smart move. In 1993, when burgeoning health maintenance organizations threatened to curb pharmaceutical sales, Merck bought Medco so that it would have a guaranteed distribution channel for its drugs.

But Medco grew far faster than anyone expected -- which turned out to be a mixed blessing. As sales exploded from $4.1 billion in 1994 to $26 billion last year, Medco's low-margin business dragged down Merck's overall net profit margin. In 2001, Medco accounted for 55 percent of Merck's revenue but only about 13 percent of profits. So Merck has decided that the two companies are worth more if separated.

"Medco has consumed degrees of capital and management attention that could have been devoted elsewhere," says Oakmark's Studzinski.

Gilmartin vows that the firm will resume double-digit growth in 2003, but some investors don't want to wait. "I have no doubt that Merck will return to being a great company," says John Hancock's Miller. "But do I have to own it today?"

Others counter that buying drug makers when they're down is often highly lucrative. "Historically, if you've bought a pharmaceutical when the pipeline is bare, you've generally been rewarded three years out," says Ray McCaffrey of PBHG Large Cap Value. "Those stocks have been good performers because their pipelines have steadily improved. It goes through cycles."

In Merck's case, you also get to pocket a healthy dividend of 2.2 percent while you wait for a rebound. And the stock looks fairly cheap. At $63, McCaffrey reckons that it's trading at a discount of more than 10 percent to what it's worth.

Marsico Funds' analyst Jennifer Saccomano estimates that Merck's pharmaceutical business alone trades at 16 times estimated 2003 earnings vs. roughly 20 times for its peers. As growth improves, she thinks that multiple can expand to its historical level of 23 times the next year's earnings.

One bargain hunter who has moved aggressively into the stock lately is Oakmark's Nygren, who snapped up 1.3 million shares in the last three months of 2001. As he sees it, Merck "trades at a discount to the S&P for the first time since Hillary Clinton tried to reform the health-care system" nine years ago.