SHARES of drug makers are usually in demand when the economic
outlook is cloudy and investors are avoiding risk. The companies'
stable earnings may be less appealing this time because the
sector faces some new risks.
Widespread calls by political leaders to overhaul the health care
system have hit the stocks, as has consternation over the feeble
state of the industry leaders' pipelines - the inventory of drugs
at various stages of development.
This is an especially critical issue today because manufacturers
of generic drugs are more aggressive, bringing their products to
market sooner. When companies do develop new drugs, regulators
are far more wary of potential risks and less inclined to approve
Some investment advisers say the sector is worth buying despite
all the problems, or because of them. The stocks have been
underrated for so long that their valuations may account for all
of the bad news but very few of the positive developments.
"Most of these companies are trading at very low multiples of
earnings," said Damien Conover, an analyst at Morningstar. "They
only need a couple of blockbusters to move the needle on earnings
and get some multiple expansion."
Some anticipated blockbusters seem to be just plain busts. The
stocks of Merck and Schering-Plough sank last month, taking much
of the sector with them, after a study found that their joint
cholesterol treatment, Vytorin, formed by blending two other
drugs, was not significantly more effective than Zocor, one of
the components, which is available in generic form.
That provides a buying opportunity in Schering-Plough, according
to Mr. Conover, who said the sellers of the stock have ignored
several promising events, He highlighted its recent acquisition
of Organon BioSciences, a European biotechnology company that
should expand the parent's pipeline and research efforts.
Other selections include Novartis, a Swiss company, and Pfizer,
which trades at less than 10 times estimated 2008 earnings and
has a 5 percent dividend yield and $20 billion of cash.
Barry Ogden, manager of the Ivy Capital Appreciation fund, likes
the other Vytorin casualty. Merck is valued at just 12 times
earnings, which he said underestimates its strength in
cardiovascular and diabetes treatments and ignores efforts to cut
costs by measures like trimming its sales force.
His other favorites include Abbott Laboratories, which produces
diagnostic and nutritional products in addition to prescription
drugs, and Gilead Sciences, a global leader in H.I.V. drugs.
Some investors have shifted into midsize biotechs like Gilead
that have products on sale or in advanced stages of development.
These companies could remain independent or become acquisition
candidates for big drug makers with more money than ideas.
Mr. Conover's biotech of choice is Biogen Idec. It has a strong
portfolio of treatments for cancer and multiple sclerosis, and he
thinks Pfizer could do worse than to use some of its cash
stockpile to take over Biogen and "buy some growth."
ONE reason there is so much growth in biotech companies is their
focus on large, complex molecules called biologics. They are hard
to make, so companies can charge more for treatments based on
them, and their complexity makes it more difficult to produce
generic versions, Mr. Conover said.
He finds the threat from generics the biggest impediment facing
the industry and its shareholders. For Mr. Ogden, the main source
of low price-earnings multiples is politics, not commerce or
science. Concern that a Democratic president and Congress would
try to force drug makers to lower prices has depressed the
sector. Whether or not it happens, Mr. Ogden said, the anxiety
about it is overdone.
"Even if reimbursement rates don't change and there is no
restructuring of the system, fear of it could pressure multiples
further," he said, "but at these valuations, you've got to be
predisposed to build positions in some of these names."