Now that patent expirations are dropping, the drug sector is getting (oddly) harder: Here are my five picks

12/07/2012 8:30 am EST


Jim Jubak

Founder and Editor,

For the world’s big drug companies, it’s the end of the dark nightmare.

You know the one where they wake up screaming because they’ve dreamed that every drug they produce has gone off patent and generic drug makers, like zombies, are marching to eat out their hearts?

Well, it’s not quite the end of the dark. But it is the grey light before dawn when the worst seems to be over.

But you know what that means right? You’ve seen this movie? New dangers threaten just when everyone thinks the coast is clear. Zombies everywhere.

That nightmare sent CEOs into frenzies of mergers and spin-offs and R&D cuts and R&D expansions and what-have-you. But it didn’t stop drug stocks from doing very well by investors. The stocks have in fact climbed that wall of extreme worry to deliver stellar outperformance over the last two years.

HOWEVER, in the what-have-you-done-for-me-lately world of stocks that outperformance means investors need to rethink their strategies now that patent expiration worries are receding. It’s not that some drug stocks won’t be big winners over the next year; it’s just that I don’t think investors can count on the rising-tide-lifts-all-drug-stocks environment of the last two years.

So how do you think about drug stocks now? On the surface that seems like a strange question to be asking.

But I’m asking. In this post I’ll tell you why I think that is the right question to be asking now. I’ll suggest a way to answer it—and a way to think about drug stocks. And I’ll give you the name of five drug stocks that I think stand a good chance to outperform what I think will be a still profitable but trickier to navigate sector.

In 2011 the SPDR S&P Pharmaceuticals ETF (XPH) returned 12.73% to the 1.89% return on the SPDR S&P 500 Trust ETF (SPY). In 2010 the drug ETF returned 22.46% and the S&P 500 ETF returned 15.06%. You have to go back to 2009 to find a year when the return on the drug ETF (at 27.65%) and the S&P 500 ETF (at 26.37%) were roughly equal.

And given that 2013 looks like the year when the feared patent expiration monster starts to get chopped down to size, you’d think that the sector might be looking at even better times ahead.

In 2012 40 drugs owned by the Pfizers and Mercks and Eli Lillys of the world saw their patents expire. Annual sales of those drugs losing patent protection? $35 billion.

Next year looks great by comparison. The total sales of drugs expected to lose patent protection in 2013 is projected at just $17 billion, according to Credit Agricole Securities.

So why does this look like a tougher environment for drug stocks? Let me give you five reasons.

  1. The fear of patent expirations is largely behind many big drug companies and investors have priced that event—and the lack of fear—into the prices of many drug stocks.

  2. Healthy dividend yields turned the sector into a defensive play in a volatile market, which means some of the more defensive drug stocks—Johnson & Johnson (JNJ), for example, seem expensive if you factor the increased uncertainty from potential changes in the tax rate on dividends.

  3. The patent expiration cliff has left its mark in the sector with some companies—Pfizer (PFE), for example--downsizing and cost-cutting into what resembles a defensive crouch. (It’s hard for me to conclude that the best use for the proceeds from Pfizer’s sale of its nutrition unit to Nestle (NSRGY) is to help fund a $10 billion share buyback.)

  4. The expiration of so many patents in such a short time led to a sometimes-frantic effort to put more potential drugs in the pipeline. That seems to have increased the pressure on drug company research and seems to be leading to an increase in the failure rate (or at least the visibility of failures) of drug candidates during trials (Bardoxolone at Abbott Laboratories (ABT) is an example) or the pursuit of drug candidates that offer only modest improvements over existing drugs.

  5. Recessions and budget crises in much of the developed world have put pressure on drug reimbursement schedules from government and private sector insurers. Everybody rightly expects that pressures on drug prices will increase, but no one is quite sure at what pace or exactly how. And no one knows how downward price pressures will balance out with the expansion of the number of insured as a result of programs such the Affordable Care Act (known by more people as Obamacare.)

Okay, so in this kind of environment what should you be looking for in a drug stock?

  • A Johnson & Johnson strategy at a less than Johnson & Johnson price. Johnson & Johnson is expensive—a PEG (PE to earnings growth) ratio of 2.15 on projected 2012 earnings per share—for a reason. Its combination of industry leading businesses in drugs, diagnostics, medical devices, and consumer products gives the company amazingly predictable earnings growth. (It doesn’t hurt that Johnson & Johnson is really good at what it does with #1 or #2 positions in many of its units.) But that story is very well known by investors and in buying Johnson & Johnson you’re paying not only for that stability but also for the company’s reputation for stability. Investors are willing to take a lower return—which means that they’re willing to pay more—because they know this story. I think you can get an equivalent stability from the diversification at Roche Holdings (RHHBY in New York and ROG.VX in Switzerland.) The company has a major and growing global franchise in cancer drugs and a solid diagnostics unit that is #1 in in vitro diagnostics. The New York traded ADS sells at a PEG ratio of 1.73. Even cheaper and more diversified—at least until it splits into two companies in early 2013—is Abbott Laboratories (ABT.) I’d hold through the split—the stock has been a member of my Jubak’s Picks portfolio since September 2010—into a AbbVie, a company that gets the current proprietary drug unit, and Abbott Laboratories, a company that gets everything else because there’s a very good chance that another drug company will make a bid for AbbVie. The PEG ratio on the combined company is 1.26.

  • A big, fat, potentially profitable pipeline with lots of drug candidates that are relatively close to market.  Novartis (NVS in New York and NOVN.VX in Switzerland) fits this bill. The company told the audience at its recent investor day that it has a target of 14 blockbuster drugs by 2017. (That’s an increase from a 2011 forecast of 7 blockbusters by 2017.) Among those blockbusters, the company believes, will be Afinitor for breast cancer. (The company increased its 2017 sales forecast for Afinitor to $2 billion from $1 billion.) The pipeline looks like more than enough to offset the erosion on Glivec, which will lose patent protection in stages through 2023. Novartis has one of the most cost-effective drug research operations in the industry. The company spends about $4 billion per new molecular entity versus the industry average of $5 billion. I think Sanofi’s (SNY in New York or SAN.FP in Paris) pipeline is also impressive. Cancer drug Zaltrap and diabetes drug Lyxumia look to have blockbuster potential. Sanofi is managing the decline of Lovenox, an antithrombotic drug that now faces generic competition in the United States.

  • Dominance in a big but concentrated market. That allows a drug company to leverage research spending on its existing knowledge base and to build up the kind of marketing unit that can get a new drug to market quickly and that can defend existing franchises. The drug company that best fits this description is Denmark’s Novo Nordisk (NVO in New York and NOVOB.DC in Copenhagen.) I’ve written about this drug company, a leader in diabetes drugs and the world leader in insulin, frequently lately. The last time was just this past Tuesday, December 4. My thinking hasn’t changed much in three days. Here’s the link to that post

You’ll note that I haven’t included current Jubak’s Picks member Bristol Myers Squibb (BMY) in my list of five drug stocks I like. I will be selling those shares out of the portfolio today and replacing them with shares of Novartis. Look for the write ups.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Novo Nordisk as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at
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