Election Is Bad News for Drug Stocks

11/11/2010 11:21 am EST

Focus: STOCKS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of Short-Side Trader, says big drug companies aren’t helping themselves with big price increases, and they may pay for it when the new Congress convenes.

I live inside the Washington, DC Beltway, along with many people who are part of politics and the government. No one has ever seen the atmosphere so vicious, so partisan, and so unproductive. And no one sees any change except for the worse.

[The gridlock resulting from last week’s election] will also create uncertainty about health care, taxes, financial reform, pension reform, etc.

The big winners, besides the companies that do the political advertising, will be the oil drillers who will do well with a Republican House [of Representatives].

The losers will be Big Pharma, which, surprisingly to many, won't do well with a Republican House, so I'm recommending a Big Pharma play with puts on the Pharmaceuticals HOLDRs (Amex: PPH).

Key ingredients of the health care package created by the White House—resulting in health care reform legislation—[included] a voluntary agreement by Big Pharma to restrain or lower the prices of drugs to save many billions of dollars. So far, the agreement has not been worth the paper the headlines were printed on.

Virtually every American ever surveyed thinks drug prices are too high, and so do many members of Congress on both sides of the aisle. It's an easy and smart move to side with the people/voters who have to pay the high costs—and big drug companies don't help themselves with double-digit price increases during the Great Recession.

Some of the larger companies, like Pfizer (NYSE: PFE), are being buoyed by outsized dividends and stock buybacks. They'll continue the practice into 2011, but government pressure to keep a lid on prices and the outsized dividends are going to run squarely into the pressure to hold down prices. Something will have to give.

I firmly expect both parties will put a great deal of pressure on Big Pharma to restrain prices. The problem for Big Pharma is that price increases are the only way many of them are increasing revenues. Plus, European governments, which have the legal authority to negotiate prices, are going to hit [them] even harder as austerity spreads across the continent.

The PPH is a good way to sidestep possible earnings surprises, merger surprises, and dividend surprises, and still make money as this sector struggles and fails. The PPH is a very concentrated ETF, with the top ten holdings comprising almost 90% of it. Merck (NYSE: MRK), Pfizer, and Johnson & Johnson (NYSE: JNJ) account for almost 60% of the PPH, and these three companies [are] supporting their stocks with high dividends, not revenue or profit growth.

I'm recommending the Pharmaceuticals HOLDRs February (2011) 65 Puts (PPH110219P00065000), with a Buy Under price of $2.65. Please note that this ETF trades with a rather wide bid/ask spread, so use limit orders and do not chase this price above $2.65. (PPH closed below $65 and the puts traded at $2.45 Wednesday—Editor.)

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