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Pharmaceutical Stocks - Cheap and Safe!

Vik Mehrotra

For the investors who are sick and tired of the wild gyrations on Wall Street and want to make a decent return with low volatility, the pharmaceutical sector offers unique value at this moment. Being a defensive sector, it usually appreciates when the market goes down. However, this time it has been different due to industry specific reasons.

Sector Woes!

Primarily, several major drugs coming off patent soon along with the expectation of a slow approval, from FDA, for new drugs, are affecting the sector. Industry analysts consider the pipeline of new drugs, coming for approval for the rest of 2002, very poor. There is also talk about a medical bill being introduced in Congress, later in 2002, which will expand the use of generic drugs and possibly put a ceiling on the prices charged by brand name drug companies. These fears have depressed the whole sector and many major companies are trading at a 52 Week low.

Compelling Valuations

From a historical perspective, several major companies are trading at the low-end range of their valuation. Merck at $61, trades at a current P/E of 18, while historically it has commanded a P/E between 18-35, with average being 26. Merck has been quietly working on a vaccine for AIDS, which has shown promising phase I results. Similar low valuation is accorded to Schering Plough (at $34) and Bristol Myers (at $49). Pfizer at $40 has traded between $35-45 for almost 2 years now, even though it has one of the best pipelines of new drugs. SmithKline Glaxo and Aventis are near their new lows as well. Only Abbott Labs and American Home Products are trading near their 52 Week highs.

Much Ado About Nothing

The drugs’ coming off patent is a valid argument, especially in light of blockbuster drugs like Claritin from Schering coming off and the patent extensions being rejected. However, it may be noted that the new pipeline of drugs for 2003 is very strong and historically, most big drug companies have well diversified portfolios and they are able to find a replacement for the loss in sales from a patent expiration of a blockbuster drug. The 2002 drug pipeline may be slow but new approvals are expected to accelerate in 2003. Also, the biotech sector has become a good source for new drug development. Many big pharmaceutical companies support and co-develop drugs with biotech companies, eventually either buying the biotech company or co-marketing the drug with a revenue sharing arrangement. Definitely, the pipeline is not slow as market is evaluating and essentially is taking a very short-term view.

The proposed reforms are not going to affect major drug companies. Their lobby in Washington is very strong and historically they have always prevailed over any kind of drug price cap reform. This is evident from the final outcome of the 1993 reforms proposed by Hilary Clinton. The expanded use of generics will not matter to the big drug companies as most of the money they make is from patent controlled drugs.

Due to these factors a classic fear psychology has gripped the analysts and investors and the stocks have become mis-priced to their future potential and safety.

A Safe Opportunity

Investors have forgotten that this is a recession proof industry and a high margin business. The dividend yield on many drug companies has not been so good for a long time and the valuations make them a compelling buy. These companies will grow anywhere between 10-20% in the next decade and have a history of raising dividends. Investors, who are seeking a secure place to invest with great upside potential should take advantage of the short-term misplaced fear amongst analysts and investment community. These stocks should be acquired, at these historically low valuations, for the long term. A similar crises of confidence emerged in 1993 and those that took advantage of it benefited in the next 8 years with an annual appreciation of over 20%.

This is not a recommendation or a solicitation to buy. All investment decisions should be made after consulting with an investment adviser based upon an investor’s investment objectives. This is not a guarantee of performance and the views are solely that of the author, whose clients can be long and/or short and/or hold option positions in any of the securities mentioned at any given time. Write to: vikm@venuscapital.com

(Vik Mehrotra, Venus Capital, Boston, is a Registered Investment Adviser with SEC and manages India Technology Fund and is a managing partner at venture capital firm, Voyager VP. )

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