Just What the Doctor Ordered for the Ailing Portfolio

A quick glance at some of the major pharmaceutical companies will show that many of their stocks have tanked recently. Concerns about safety issues, and the fear that the Food and Drug Administration may not be doing its job, have set off a wave of selling that is apt to continue for some time.

But a closer look at the industry as a whole, and the hardest-hit companies in particular, shows great potential for the medium- to long-term investor.1

There are a number of trends that point to one inescapable conclusion: When it comes to the big pharmaceutical companies, what comes down must go up. People aren’t going to stop taking drugs, and big drug companies are not going to stop inventing blockbusters.

The troubles began last September 30, when Merck & Company withdrew Vioxx from the market after research showed that people who had been on it for a year and a half were twice as likely to have heart attacks. Merck was looking at an immediate hit of possibly $18 billion in legal costs, and its stock plunged from around $45 to well under $30 within a few weeks. Since Vioxx’s withdrawal, Merck has lost $28.1 billion in market capitalization ? 30 percent of its value ? and is cutting 5,100 jobs.

We had all seen drug companies stumble before, but then on December 17, Pfizer, Eli Lilly, and AstraZeneca all made disastrous announcements. Pfizer said its hit drug Celebrex increased heart attacks. Lilly added a boldface warning to its drug Strattera, and AstraZeneca said its widely-used lung cancer drug had proven no better than a sugar pill. This seemed like too much coincidence, and the market responded harshly.

Pfizer lost 7 percent, AstraZeneca tumbled by 10 points, and Lilly lost 4 percent. The Standard & Poors Pharmaceutical Index went down 10 percent, while the overall S&P 500 was moving up 9 percent. When it comes to drug companies and the huge liability they face from adverse patient reactions, the market is hypersensitive to bad news. But when you look at the facts and trends, you see quite a different picture.

For one thing, Lilly’s Strattera has been in use by two million people in addition to the 6,000 who took part in clinical trials ? all without adverse reactions. Lilly’s warning label was simply a precaution taken when two patients experienced liver injury, which may or may not have been caused by the drug. They both recovered.

Still, some stock analysts are advising their clients to stay away from pharmaceuticals, despite the historical fact that drug stocks are among the most profitable investments, and that aging baby boomers are requiring more medicine all the time.

As baby boomers age, as new technologies come on line, and as the FDA streamlines its approval process, more drugs are being brought to market faster than ever before. Managed care, in addition, encourages drug therapy as a replacement for more expensive hospital care where possible. And for many types of drugs, people have no choice but to take them, sometimes for life.

The upshot of the bad mood among investors is that pharmaceuticals may be one of the best bargains in town right now.2 There are five related trends that point to this:

The products that pharmaceutical companies sell are a necessity. In most cases, the drugs are also purchased repeatedly. Patients have to keep buying them for as long as their doctors keep writing prescriptions. In addition, drugs are a high-margin business, sometimes reaching 30 percent; that’s twice the margin of the average S&P 500 company. Moreover, patent protection guarantees a 20-year monopoly.

The world’s population is getting older. As people age, they use more drugs. People over 65 use three to four times the prescription drugs that people in their 30s use. As boomers age, the population of people over 65 in the U.S. will grow by 17 percent by 2010. The $105 billion pharmaceutical market is set to balloon as those people demand more and better drugs. That doesn’t even include the rest of the world’s demand. All told, the market for drugs worldwide is already $188 billion, and that should grow even more rapidly than the U.S. market. American companies control 30 percent of that total, with their market share on the upswing.

Pharmaceutical companies directly benefit from new techniques of science and technology, which usher in new drugs all the time. This means that the product lines for these companies are getting bigger all the time. This moves in lockstep with scientific advances, which are accelerating. Medical science has made as much progress in the last 15 years as it did during the preceding 40 years. Drugs like Prozac, Zoloft, and Viagra are part of this scientific bounty. This puts pharmaceutical companies in a unique position to grow without diluting their brands, straying from their core competencies, or confusing customers. And they have an insatiable market: No one is ever going to complain that there are too many cures and not enough diseases to go around.

The FDA has undergone reforms in the past two years that make it faster than ever to get a drug approved. Approval used to take an average of more than two years ? and in many cases, more than three years. By 1998, the average was a little bit less than a year. And today, the FDA has a “fast track” that can shepherd a vital medicine through the process in a mere six months. Since patent rights begin with the patent application, and not the introduction of the drug to the market, this means that big profits begin sooner and the monopoly lasts longer. And the faster process even makes failure less costly, as companies cut their losses sooner.

HMOs and other managed-care providers prefer drugs over hospitalization. Even when the drugs are expensive, they rarely match the cost of a hospital stay. As newer and better drugs keep people healthier, managed care providers are likely to continue favoring them, once again supporting high profits among pharmaceutical companies.

In light of these strong trends, we’d like to offer the following five forecasts for your consideration:

First, in the short term, the major pharmaceutical companies that have taken a hit recently in stock price will recover and move into even more profitable territory. Drug stocks have traditionally been in a category of investment that yield either extremely high or extremely low payoffs, so they are not without risk. However, the trends clearly indicate a long-term and growing need for drugs. Investors will inevitably see that value and push the prices back up.

Second, as the world’s population ages, there will be increasing demand for safe and reliable drugs. Both the FDA and the drug companies will have to respond by setting standards of very high utility and quality. After harsh criticism of the FDA, even from its own scientists, a shake-up at that agency is likely. Since the drug companies rely on the FDA’s imprimatur, it is vital that the agency’s image be protected.

Third, as biotechnology companies mature, whole new classes of highly targeted drugs with few or no side effects will appear. In part, that will be the answer to the problem of reliability we just mentioned. In addition, this will provide a whole new family of revenue streams in the industry. Successful small companies will be snapped up by giants like Lilly and Johnson & Johnson, whose profit picture will then benefit from the success of those new drugs.

Fourth, tort reform is a likely winner within the next two to three years, as people realize that they’re paying for those huge settlements in the form of higher drug prices. This is high on Bush’s second-term agenda. In addition, the assumption that drug companies will be hit with huge lawsuits is already factored into the stock price. With tort reform, the stock price would naturally rise. With Republicans firmly in control of Congress and increasing their clout in the courts, the balance of power has shifted away from trial lawyers and toward defendants. Look for strict caps on judgments and many more restrictions on class-action suits.

Fifth, the Federal Government will enforce a ban prohibiting Americans from re-importing drugs from Canada. Two reports released on December 20th by the Department of Health and Human Services3 and the U.S. Commerce Department4 state that this practice poses safety risks and wouldn’t really save much money in the long run. Nevertheless, without a ban, the flood of imports would cut into drug company profits and diminish development of new drugs. The report noted that in 2003 about 12 million prescriptions valued at $700 million were imported from Canada by way of Internet sales or people visiting there. Since it would cost an estimated $3 billion to oversee individual importation, that, too, will likely be banned. In the end, patients will see that using generic drugs can save them more money ? an estimated $17 billion ? than relying on potentially unsafe imports from unapproved foreign labs.

References List :
1. Associated Press, December 24, 2004, “Drug Concerns Hit Pharmaceutical Stocks,” by Rachel Beck. ⓒ Copyright 2004 The Associated Press. All rights reserved.2. To access Jeff Fischers analysis of pharmaceutical stock potential, visit The Motley Fool website at:www.fool.com/news/indepth/pharma.htm3. To access the governments report on prescription drug importation, visit the Department of Health and Human Services website at: www.hhs.gov/importtaskforce/Report1220.pdf4. To access the governments report on pharmaceutical price controls, visit the Commerce Departments website at:www.ita.doc.gov/td/chemicals/DrugPricingStudy.pdf