Drug Stocks Still Have Some Benefits
By GREGORY ZUCKERMAN
Staff Reporter of THE WALL STREET JOURNAL
January 2, 2005
For investors in 2004, the drug business delivered a dose of bad medicine.
The Dow Jones U.S. Pharmaceutical Index fell about 10% during the year, with losses of more than 3% since August, even as the overall stock market charged higher. Pharmaceutical stocks are down about 17% in the past five years. For some of the biggest drug companies, the pain has been much deeper. Shares of Merck, which pulled its top-selling pain medication Vioxx after concerns were raised about potential links to heart attacks and strokes, dropped 30% in 2004.
Meanwhile, the drug business is more competitive than ever. And it is seeing an outcry from consumers and lawmakers about the high prices charged for drugs, as some people anticipate regulatory efforts to stem the increases.
All this has forced investors to re-evaluate the entire business. In past periods when the drug companies had snarled drug pipelines or came under pricing pressure, investors who bought shares were rewarded. That's because it is a cyclical business, and the next big-selling drug could be just around the bend. Indeed, in the mid-1990s these stocks climbed just a year or so after jitters about pricing pressures.
But lately, more investors have begun to worry that the pharmaceutical industry's maladies will linger, with growth hindered.
Bottom line for investors: Drug stocks should still play a role in the portfolios of investors looking for steady earnings and high dividends. And the lower prices of these shares make them more attractive for long-term investors who can stomach the risk of short-term zigzags. But these companies no longer should play a prominent role in most portfolios because their growth could be subdued for some time.
[Bitter Pill]
After all, pharmaceutical companies have found it much harder to develop profitable new treatments in recent years. At the same time, worries grew all year about the safety of current blockbusters like Merck's Vioxx and Celebrex, made by Pfizer. Late last week came word from a British medical journal that Eli Lilly's big antidepressant drug Prozac might be linked to violent behavior. Eli Lilly shares fell about 1% on Friday on the news, a fitting piece of news to cap off the year for these companies.
But rough patches for certain sectors can open the door to opportunity for investors. About a year ago, for example, most analysts wrote off Eastman Kodak, figuring the film maker couldn't turn its operations around. But Kodak was so unloved, and its stock so cheap, that its shift into digital printing sent its shares up 26% in 2004, as some investors got back on board.
Similarly, some savvy investors are looking for attractive drug stocks to buy, now that they are selling at possibly bargain-level prices. There are some big positives for drug stocks, despite the imposing problems.
While they no longer are boosting profits at impressive rates, their earnings continue to be steady and sizable. And these companies carry little debt and sell products that should become even more crucial to customers, as the population in the U.S., and many other countries, ages in the next few decades. The best way to view the industry is as one that could generate steady profits for the next several years, but without the heady growth of the past.
And don't forget the dividends, which get a more favorable tax treatment thanks to the tax change of 2003. Merck has a dividend yield of almost 5%, while Bristol-Myers Squibb has a dividend of more than 3%.
This new view is part of the reason Pfizer shares have rebounded to about $27 from about $21 in the past two weeks, though they are still far below the 52-week high of almost $39 in February of last year.
"I would be a buyer at these levels," says Jack Ablin, chief investment officer at Harris Trust in Chicago. "Over the next 12 to 18 months we think health care will outperform." He says both Merck and Pfizer "appear washed out, suggesting there's little downside left. Now that they're getting some momentum, these stocks could be interesting additions" to investor portfolios.
Adds James Gipson, a noted value investor who manages Clipper Fund: "On a contrarian, value basis, [drug stocks] have some interest. For most of these companies, when the business model works, it works very well, and even Merck, which is yielding about 5%, currently has a good business with good cash flow, and is generating high returns on capital and equity."
It's all been a big shift for these stocks, from the life of the stock-market party to the ugly ducklings. In late 1998, pharmaceutical stocks traded at 40 times their expected earnings for the following 12 months, as investors anticipated a long-term surge in profits. Today, these stocks trade at about 14 times their expected earnings, the cheapest level in eight years. In comparison, companies in the Standard & Poor's 500-stock index trade at about 17 times expected earnings for the next four quarters, making drug stocks look like bargains in comparison. As recently as August, pharmaceutical stocks traded at a higher price-earnings multiple than the overall market. Another sign of the value: Drug stocks as a group now sport annual dividend yields of about 2.4%, up from as low as 1.13% in 2000, attracting some investors.
And drug stocks make up about 7% of the S&P 500, down from 11.4% in October 2001, when many investors shifted from technology to pharmaceuticals, in search of better prospects.
Lost in all the downbeat headlines has been upbeat news from some companies. For example, the Food and Drug Administration recently approved Macugen, a drug designed to slow the loss of vision in patients with a type of age-related macular degeneration that causes blindness. The drug was developed by Eyetech Pharmaceuticals along with Pfizer.
Value-oriented investors, like Pzena Investment Management, are stepping in. Pzena, a New York money-management firm with $10 billion of assets, has been buying up shares of Bristol-Myers Squibb, figuring the stock is so cheap that if the pipeline of new drugs improves it will be icing on the cake. But even Pzena executives are tempered in their enthusiasm for many drug companies. Their concern: a stream of lawsuits likely against some of the top drug makers, which could cast a shadow over the stocks.
Write to Gregory Zuckerman at gregory.zuckerman@wsj.com1
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