The Worst Investments of 2010: Big Pharma

The bad news was already priced in, and upcoming health reform promised good news to come. It didn’t happen.

This year’s foggy investment landscape hid plenty of manure, and some of it stuck to some very big shoes.

Of course, some of the biggest losers of 2010 will turn into winners one day. But not overnight, and certainly not because the calendar has turned over.

This Was the Script
After the heady risk rally of 2009, Big Pharma was a fashionable choice to outperform in 2010 as investors came around to shop for value. Looming patent expirations were no longer news, hence the cheap valuations and ample yields. The Democrats’ proposed health reform could be spun as either a pipe dream or else a revenue opportunity, given its goal of extending coverage to most Americans.

This Is What Happened
The health reform was enacted, and Big Pharma was widely judged to have dodged a bullet on drug reimportation and the like by kicking in a mere $80 billion in reduced drug costs over 10 years. But then it was back to the drudgery of inventing and making drugs, and that’s not something the industry finds as easy as Washington lobbying.

Pfizer (NYSE: PFE) began its year starting to integrate the pricey acquisition of Wyeth, and ended it bidding adieu to the CEO who engineered the merger. He was deemed by the board too stressed to cope. You would be too if your hypertension drug had flopped and your onetime star Lipitor was subjected to the indignity of a partial recall over a foul odor. A year after swallowing Wyeth, Pfizer reported earnings that fell short of estimates. Revenue was up 39% post-merger, but expenses rose 43%.

Johnson & Johnson (NYSE: JNJ) had to undertake a half-dozen recalls of infant Tylenol and many other over-the-counter medicines because of serious shortcomings at the manufacturing plant. Its hip implants also proved defective. Like Pfizer, J&J is feeling the effect of patent expirations. Shares are down 4% this year, vs. a 6% setback for Pfizer.

Other big drug makers have suffered an even bigger market letdown in 2010. Abbott Labs (NYSE: ABT) has lost 11%; Sanofi-Aventis (NYSE: SNY) shed 18% this year; and even generics kingpin Teva (Nasdaq: TEVA) has seen its shares drop 9%. But J&J and Pfizer symbolize the industry’s failure to execute or to provide sufficient value.

Who Got Hurt    
Warren Buffett is J&J’s most famous shareholder, and while the Oracle of Omaha smartly sold more than a quarter of Berkshire Hathaway’s (NYSE: BRK.B) huge stake late in 2009, he bought a lot of that back too soon in the first half of 2010.

Noted value investor David Einhorn probably regrets making Pfizer his top holding early in the year. But he bought another 5 million shares during the second quarter’s thumping, and the ensuing third-quarter rally swelled his stake from $330 million to $397 million, though that’s no longer Greenlight Capital’s biggest allocation.

Smaller investors got burned as well. Big Pharma’s inert heft was among the reasons large-cap index funds lagged so much behind their midcap and small-cap counterparts this year.

How Far Is Down
Perhaps not much, if any, further. Pfizer’s chart, though hardly a picture of long-term health, does how that the stock held a test of its 200-day moving average and is now hanging around the stabilized 50-day. J&J is also aiming to prove that the autumn rally wasn’t just a counter-trend. Investors may be growing more comfortable with the Obama Administration’s more skeptical and activist Food and Drug Administration. But conventional drug makers still labor under the suspicion that the best new drugs are coming out of biotech labs these days, while old guard can barely manage to repackage aging remedies.

How Soon Is Up
A real recovery could take longer than the bottom-fishers currently expect. Drug stocks are the sort of defensive sector people buy when the cyclical upturn seems to be petering out, and 2011 isn’t shaping up as that kind of year. Furthermore, the growth-challenged behemoth’s yields will look less tempting if interest rates rise, as has already started to happen.