NEW YORK (MONEY Magazine) -
As long as Americans keep getting older, there's money in pharma. Risk: No one's sure how much is in the new-drug pipeline.
Let's be clear: This is a contrarian bet appropriate only for patient, risk-tolerant bargain hunters.
"The time to buy is when there's blood on the streets," says manager John Buckingham of the Al Frank Fund, channeling Nathan Rothschild. "It's hard to imagine it getting any more bloody than in the drug sector."
For starters, there are the headlines about Merck's withdrawal of the popular pain-reliever Vioxx over concerns that it may increase the risk of heart attacks.
But even more worrying to Wall Street is the fact that many blockbuster drugs are losing their patents in the next few years, meaning that generic knockoffs can flood the market and drive down prices. And there aren't enough new pills on the way.
As a result, the typical major drug company now trades for just 14 times profit projections vs. a P/E of 17 for the S&P 500. This despite the fact that drug companies' average net profit margin is a fat 20 percent and their dividends to shareholders run at about 2.5 percent.
And the demand for drugs is obviously growing as baby boomers age -- some Lipitor with your steak? -- and life expectancies increase.
Still, for the pharmas to really be a bargain, you have to believe that all those worries about the shortage of new drugs are overdone. They are. Over the past 10 years, the FDA has approved an average of 32 new drugs a year.
Meanwhile, the industry is spending $33 billion on research and development, up from $8 billion in 1990, and it's a good bet that this will produce a few more billion-dollar drugs. Of course, the process of getting any of these drugs approved will take years, and Wall Street has a hard time looking beyond 2006.
"If you are looking at the group, there are products in the pipeline or in approval that should offset expiring patents," says Douglas Christopher, a pharmaceutical analyst with Crowell Weedon & Co. "The trouble, on a company-by-company basis, is timing."
For investors with a three- to five-year outlook, though, Wall Street's short-term focus appears to have created a historic opportunity to pick up traditional growth stocks at value P/Es.
Since it's not obvious which companies' R&D spending will pay off (and once it is obvious, those stocks won't be bargains), your best bet is just to buy 'em all. Ross Levin, a financial planner in Minnesota, recommends buying "a bucket of pharma" through an exchange-traded portfolio.
The only one that focuses exclusively on drug companies is Pharmaceutical HOLDRs (Research). More than 85 percent of it is invested in the eight biggest U.S. drugmakers. It can be bought through a broker like any stock, but you have to buy a round lot of 100 shares.
Another way to bet on the industry's comeback without worrying about the state of any one company's product pipelines is through IMS Health (Research), a consultancy that was spun out of Dun & Bradstreet in 1996.
IMS collects information from 29,000 data suppliers from over 100 countries, including drug manufacturers, retailers, pharmacists and hospitals. Then IMS sells back its findings to the folks who originally supplied it. It also advises companies on drug launches and is hired to fire up sales forces.
The stock is weighed down by negative perceptions of the drug industry, but over the past 12 months, IMS booked net profit margins of 19 percent on sales of $1.5 billion. Wall Street expects it to grow earnings 13 percent in 2005; at a recent $22 the stock had a P/E of just 17.
"IMS has all of the positive characteristics of drug companies combined with the attributes of data companies -- that is, great cash generation, predictability and low incremental capital needs to support growth," says Bill Nygren of the Oakmark Select fund. IMS is among his top holdings.
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