Bargain Drug Stocks Are Good Medicine
By James K. Glassman
Sunday, May 23, 1999; Page H01
Shortly after Bill Clinton was elected president in 1992, investors were
worried about his proposal to overhaul health care and began to sour on
pharmaceutical stocks. Pfizer Inc. (PFE) plunged by one-third; Amgen
Inc., the biotech firm, fell by more than half; and Merck & Co. (MRK)
dropped 40 percent.
These sharp declines offered one of the great buying opportunities of the
past decade. If we're in luck, we may be getting another one.
After an incredible five years, drug companies have suddenly fallen out of
favor. Merck, for instance, returned an average of 43 percent a year from
March 1994 through March 1999. But over the past two months, its price
has dropped from $86.37 1/2 to $71.31 1/4--a loss of nearly 20 percent
while the market as a whole rose 4 percent.
Pfizer, maker of Viagra; Amgen, whose top products include the
anti-anemia drug Epogen and immune-system stimulator Neupogen; and
Schering-Plough Corp. (SGP), which makes the anti-allergy medicine
Claritin, have each lost one-fourth of their value. Eli Lilly & Co. (LLY),
maker of Prozac, has lost even more.
What is remarkable is that this devastation is occurring while the drug
companies continue to make lots of money. Merck--whose drugs include
Zocor, for elevated cholesterol; Crixivan, a protease inhibitor used in
treating AIDS; and Vasotec, for hypertension--is a cash machine. Last
year the company earned $5.2 billion after taxes on $27 billion in sales.
Merck has increased its 12-month earnings by 13 percent or more for the
past 17 quarters, and analysts expect an additional 14 percent increase for
the period that ends next month. Value Line projects earnings may slow a
bit for the five years ahead, rising just 11 percent a year. But that's still
more than twice the growth rate of the economy as a whole.
Schering-Plough's record is even better, with double-digit earnings
increases throughout the decade and estimates of an 18 percent gain for
this quarter and 16 percent growth over the next five years. Still, the stock
skidded from $60.75 on April 12 to $45.93 3/4 on May 18.
What's happening? First, notes Marshall Acuff of Salomon Smith Barney,
there's the talk in Washington that Medicare will add a drug benefit. "The
logic goes [that] eventually the pricing power that the industry is enjoying
will erode as this large new customer demands concessions," Acuff wrote
clients.
The second problem is that, as the economy picks up, investors are
moving from defense to offense--away from drug companies, which are
consistent moneymakers in good times and bad, and toward industrial
cyclical stocks, which do well only in a perky environment.
Acuff said the effects of these factors will continue, and he points clients
toward stocks with "the strongest fundamentals, potential new blockbuster
drugs and relatively low P/Es," or price-to-earnings ratios.
We'll get to those selections--and those of other analysts--in a second.
But, frankly, we take a different approach. We see the current woes of
drug stocks--even those with high P/Es, such as Merck--as providing a
delightful opportunity to add terrific growth companies to your portfolio.
Political scares come and go, and so do market rotations. But drug
companies keep making money--mainly because their patents give them a
refuge from competition, their products keep getting better and their base
of customers keeps growing as Americans (not to mention Japanese and
Europeans) keep getting older.
In researching "Dow 36,000," the book I have co-authored with
economist Kevin Hassett, I became convinced that the best companies
were those with consistently rising earnings, long histories, "moats" (such as
patents) that deter competitors and (as a bonus) nice dividends. Most drug
companies have all of these assets.
The only problem has been price. Merck has a P/E of 32; Amgen, 35;
Johnson & Johnson (JNJ), 34; Pfizer, 53; Eli Lilly (LLY), 38; and so on.
But nearly all of these P/Es have dropped along with the prices of the
stocks in the past two months. Merck peaked in March at a P/E of 40;
Lilly was over 50.
Besides, a P/E in the 30s is actually modest for a company that increases
its earnings by 12 percent to 15 percent year after year, as Merck does.
Let's look at Merck's dividend. In 1989, it was 27 cents per share. Today
it is $1.12, and according to projections by Value Line it should hit $2.02
in five years. If you had invested $1,000 in Merck at the start of 1989, you
would have received $27 in dividends that year. But in 2004, you would
receive $202 in dividends--for a return of more than 20 percent in that
year alone on your original investment.
Merck, like all drug companies, is benefiting from the revolution in
biotechnology, which began in 1972 when Stanley Cohen and Herbert
Boyer formed the first recombinant DNA molecules by attaching genetic
information from one organism onto the chromosomes of another. In 2003,
the huge project of mapping the 80,000 genes in the human genome will be
complete, and we should learn, among other things, which genes are linked
to which hereditary diseases.
As a result, "biotech's payoff could be even more dazzling than what we've
seen in the computer industry, and it may arrive in the next few years,"
writes Richard Brewer in the current issue of Forbes ASAP, whose cover
asks, "Will Biotech Top the Net?"
Some small biotech firms, including Brewer's own, Scios Inc. (SCIO),
which makes drugs to treat congestive heart failure and Alzheimer's
disease, have been clobbered lately. Scios is off 65 percent this year.
Biotech companies have to put huge amounts into research, with hopes of
a payoff far down the road. As a result, their stocks are extremely volatile.
The trend in the industry has been for larger, broader pharmaceutical
houses to form partnerships and licensing agreements with the biotechs and
spread the risk.
Still, Salomon's Acuff is high on the largest biotech firm, Amgen, which last
year had sales of $2.7 billion and earnings of $863 million, and he is
especially high on Biogen Inc. (BGEN), with sales of $558 million and
earnings of $139 million. Biogen's hot drug is Avonex, which treats
relapsing forms of multiple sclerosis.
Biogen has suffered less than many other drug companies from the recent
collapse. It's off barely 10 percent. And no wonder: Earnings have been
rising at a 50 percent rate. Assume that earnings rise at half that rate for the
next five years. Even if the stock triples in price in that time, it will be
trading at a P/E of 27, which is far from overblown.
Among the larger drug houses, Acuff likes Lilly, Pfizer and Bristol-Myers
Squibb Co. (BMY) as "likely beneficiaries of new drugs this year." He
bestows a "1" rating, as well, on Schering-Plough.
Barbara Ryan of BT Alex. Brown Inc. also issued a buy recommendation
for Schering recently, but she gives even higher marks ("strong buy") to
Merck, Lilly and Warner-Lambert Co. (WLA), a wonderful company that
makes such consumer products as Dentyne gum and Clorets mints, such
over-the-counter drugs as Sudafed and Benadryl, and such
pharmaceuticals as Lipitor, the top cholesterol-lowering medication in the
country, and Rezulin for diabetes.
Warner-Lambert has fallen 12 percent since the start of the year, but
Value Line expects earnings gains of 17 percent in 1999 and an average of
21.5 percent annually through 2004. The stock pays a 1.2 percent
dividend that has been doubling every five or six years.
Morgan Stanley Dean Witter also rates Warner-Lambert a "strong buy,"
calling it an "opportunity for savvy investors." The firm's analysts see the
drug industry changing rapidly, with mergers, acquisitions of biotech and
companies with innovative technology platforms, and divestitures. The trick
is to find "management teams with the flexibility to adapt to the changing
environment."
One of those teams, Morgan Stanley believes, is at American Home
Products (AHP), which makes the popular estrogen-replacement drug
Premarin and owns Genetics Institute Inc. and a majority share of
Immunex Corp. (IMNX), a biotech firm that makes drugs that fight cancer
(Novantrone) and rheumatoid arthritis (Enbrel).
If you would rather have an expert pick your drug stocks, Sheldon Jacobs,
editor of the No-Load Fund Investor (1-800-252-2042), recommends T.
Rowe Price Health Sciences (1-800-638-5660), which has among its 10
largest holdings Gildead Sciences Inc. (GILD), developer of drugs to fight
viral diseases.
Fidelity Select Biotechnology (1-800-544-6666) holds conventional
biotechs such as Biogen (its number one asset, at 9 percent of the fund),
Amgen and Genentech Inc. (GNE), as well as large, diversified
pharmaceutical makers such as Merck and Schering-Plough.
Putnam Health Sciences Trust (1-800-225-1581), which has fallen 9
percent this year, has returned an annual average of 24 percent since
1994. Although managers Richard England and Carol McMullen have a
broad mandate (they even own drugstore chains), their top 12 holdings are
drug stocks, headed by Bristol-Myers.
Finally, top-rated by Value Line is Vanguard Specialized Health Care
(1-800-662-7447), which returned a hefty 41 percent last year. Its
expense ratio is less than 0.5 percent annually, compared with a sector
average of 1.7 percent.
With all these choices and with drug stocks so disliked, there's simply no
excuse for not taking your medicine.
Glassman's e-mail address is jkglassman@aol.com; he welcomes
comments but cannot answer all queries.
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