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4 ways to play the ailing drug giants
With the big drug companies weighed down by lawsuits and patent expirations, investors may want to rethink this group. Here are the options.
By Timothy Middleton
Big pharma is in big trouble. As an investor, do you take two aspirin and call back in three years -- or do something more immediate?
Legal troubles at Merck (MRK, news, msgs) from its painkiller Vioxx, as well as a wave of looming patent expirations, are siphoning off the profits of big pharmaceutical companies, which account for nearly half of the entire health-care marketplace.
So-called value investors, who specialize in troubled stocks, are swooping down on health care. "Certainly their earnings aren't going to be as strong as they would otherwise have been, and, because of that, you can pick up these stocks at good prices now," says Phillip Titzer, lead manager of Edgar Lomax Value Fund (LOMAX), which has a big stake in pharmaceuticals. "And any (lawsuit) payments they have to make will be over a long, long period of time. It's not as bleak as the market reaction would indicate."
You might be buying pharmaceuticals, too, if you own a value fund. And there's a good chance you do. Value funds fared better than their growth counterparts in the recent bear market, and they have been flooded with assets.
What should you do? Some folks might want more exposure to health care, the second-fastest growing economic sector of the last two decades -- after financial services -- and a play on the aging Baby Boomer demographic. Or you might like health as a theme but want to escape big pharma's woes. Funds allow you to calibrate your exposure as finely as you wish.
Experience shows that many investors will simply flee the group's problems, because most chase performance and performance in health care is lagging. Contrarians and bargain hunters, on the other hand, will be drawn to the blood-letting, for reasons I explained two weeks ago in " A 4-fund portfolio you can buy and hold."
Related news and commentary on MSN Money
Here are your choices.
If you want in
Health-care's problems are transitory, many experts say, and probably approaching their end.
Price-earnings ratios, relative to the market, climb with rising revenues and vice-versa, notes Tony Butler, who covers the group for Lehman Brothers. He says U.S. pharmaceutical companies' patents are expiring and revenues will hit bottom next year.
Bristol-Myers Squibb (BMY, news, msgs) loses patent protection on its cholesterol drug, Pravachol, next year. Last year, the drug accounted for $2.6 billion of the company's $19.4 billion of sales. Merck's patent for its blockbuster cholesterol-lowering agent, Zocor, also expires next year. Lipitor, from Pfizer (PFE, news, msgs), goes off-patent in 2010.
The easy way to take advantage of health-care's weakness is to own value funds and funds that follow the "dogs of the Dow" theory of investing.
The dogs theory predicts that the 10 highest-yielding of the 30 stocks in the Dow Jones Industrial Average ($INDU) will outperform the others the following year as their prices return to more-normal levels. Pfizer's dividend yield is 3%. At Bristol-Myers, it is 4.5%. At Merck, it's about 5.5%.
Payden Growth & Income Fund (PDOGX) has 5.4% of assets in Merck; another "dogs" fund Hennessy Total Return (HDOGX) has 4.3%.
You can also buy funds that invest strictly in this sector, such as Fidelity Select Health Care (FSPHX) and T. Rowe Price Health Sciences (PRHSX). The former has such names as Johnson & Johnson (JNJ, news, msgs) and Pfizer among its top holdings. The latter holds fewer big positions in pharmaceuticals and more in biotechnology and services firms.
If you want in, but
Maybe the value argument doesn't quite overcome your main concern: That tort lawyers see pharmaceutical companies as the new tobacco, an ATM machine they can freely access whenever they need cash.
Exhibit No. 1: Two weeks ago, a Texas jury socked Merck with a $253.5 million verdict in the death of an athletic 59-year-old man who had taken Vioxx, an arthritis medication. Merck has withdrawn the drug, and Texas law will require that the award be cut substantially. Still, analysts say it could face liabilities in the range of $10 billion to $30 billion from Vioxx alone.
Merck has vowed to appeal the verdict, and many analysts expect it to prevail. The Texas man, Robert Ernst, died of a heart arrhythmia, and Vioxx is not implicated in that condition. The Wall Street Journal headline on the story read: "In landmark Vioxx case, jury tuned out science, explored cover-up angle."
Merck has also said it will consider every Vioxx case individually, and perhaps settle some. There are potentially thousands of them, which could drag the matter out for years, or even decades. Other big pharma companies also produce drugs in the same class as Vioxx, called cox-2 inhibitors. Pfizer has two of them, Celebrex and Bextra.
You're not the only one who's worried. Some health-care funds are lightening up on pharmaceuticals. One of the best-performing of them, ICON Healthcare, (ICHCX), has only 14% of assets in pharma, compared with its 46% weighting in S&P's health index.
"They're selling at tremendous discounts, but they're not moving. And we get paid to invest in stocks that move higher," says J.C. Waller, the fund's manager.
If you want out
Merrill Lynch analyst David Risinger pegs Merck's potential Vioxx liability in the range of $11 billion. He says the company has $14 billion on hand, however, and generates cash flow in the range of $1 billion to $2 billion annually. Merck would pay any possible damages over a period of many years.
His concern: The impact on cash flow could reduce Merck's dividend, now $1.52 a share. "We don't think the dividend is at risk near term, but it could be at risk longer term," he wrote to the firm's clients last week.
If you fear the group will be depressed for a good long while, you can lighten up by dumping some of your value funds, despite their outstanding performance of late. Clipper Fund (CFIMX) has more than 20% of assets in health care, nearly twice the weighting of the S&P 500 index ($INX). It's buying the Pfizer shares that sellers like Waller are dumping: The drug maker is its second-largest position.
Dodge & Cox Stock (DODGX) has 15.6% in the sector and two of its five largest positions are health-care stocks.
If you like value but not health care, some outstanding funds are shunning the group entirely, including Masters' Select Value (MSVFX).
Many others are very light on the sector, including Oakmark Select I (OAKLX), Target Large Cap Value (TALVX) and Mutual Shares A (TESIX).
If you want to stand pat
There is yet another path you might choose in this controversy, and that is to ignore it. Many very long-term investors, such as the managers of Vanguard Windsor (VWNDX), have a market weighting in the group, which in Wall Street jargon is a "neutral" position.
That's my stance. I happen to own Dodge & Cox Stock, and I would neither sell the fund because I fear the drug group nor buy more because I like it. I rely on value managers to do their job, wherever that leads them.
If I wanted more exposure I would buy a sector fund. One of my favorites is T. Rowe Price Health Sciences.
But I don't want more health care in my portfolio right now, so last year I exchanged this fund for a natural-resources portfolio. That's my bow to market timing, which, like most investors, I'm not very good at but persist in trying.
Strategically, though, health care is the place to be. Since 1991, Fidelity Select Health Care has delivered annualized returns of 15.1%. Fidelity Select Energy (FSENX) has gone up 11.1% annually in the same period. With compounding, that 4 percentage point difference means the health fund would be worth twice as much as the energy fund in 17 years -- and nearly three times as much in 30.
Health care is cheap. Not all cheap securities produce investment home runs, but nearly all investment home runs begin as cheap securities.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Dodge & Cox Stock Fund.
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