Value vs. Risk in Pharma

I read Jim Cramer's article on large-cap pharma earlier this week and found myself nodding in agreement. The stocks have been atrocious, they lack obvious catalysts to reverse their seemingly perpetual slides, and the business plans need some reengineering.

Is it the bottom? I don't know. The valuations and dividend yields appear very attractive, but that is often not enough to justify an investment. The market is clearly casting a strong vote against these stocks right now. I have been slowly wading into some big-cap pharma over the last few trading days, and I think these stocks are worth serious consideration for longer-term investors, but by no means are these stocks without risk.

An investor must grapple with the following issues before deciding whether to jump into these stocks:

1. Governmental price controls. This has to be on the top of every pharma investor's mind. If the government is going to hurt pricing without a resulting increase in volume, these stocks should absolutely go down.

I believe harmful intervention is unlikely. If officials are going to take a serious swing at our dysfunctional health care system, it will likely include some mechanism for universal health care. If you increase access as you lower prices, volumes across the board would increase -- a positive offset to the drug makers.

2. Inflation. Those dividends are nice, but inflation could eat into them faster than the companies can grow them. Inflation is certainly a macroeconomic concern today, and rightly so. Without earnings and dividend growth, which is unlikely for these stocks in the near term, these dividends are less appealing.

3. Drug development is risky. The R&D engines have been stalled for years, and setbacks of drugs in late-stage development have been pervasive. With the cost of bringing a blockbuster drug to market approaching $1 billion, the ante has increased as the risk of failure has become more apparent. A cautious FDA has only dimmed the outlook.

Further, post-market setbacks have increased in recent years. There are a handful of drugs -- Vioxx and Trasylol, for example -- that were pulled from the market, and other drugs -- Vytorin and Champix -- have been shown to be less effective or have more side effects than originally believed. Investors' confidence has been overtested.

Drug development will never be anywhere close to riskless, but the generation of drugs developed from better understanding of the human genome has been steadily marching toward market. Theoretically, these drugs should be better suited for their target populations. While the target populations will be smaller as each disease category is narrowed by its subset's characteristics, the length of development time should be curtailed, and the trials should have a higher probability of success.

4. Share dilution. Increasing merger activity to backfill poor R&D productivity will dilute shareholders' value. I believe this will happen and some near-term dilution is likely, but growth should improve with these acquisitions. Big pharma would be better served by allocating R&D dollars to M&A instead, and I think we'll see that over the next few years.

5. Shift in demand. Gone are the days of inelastic demand in health care -- much of the tried-and-true defensive nature of this sector has been challenged. This is just a fact, and investors need to recognize it and adjust accordingly.

Health plans have been changing over the last several years. You have likely seen it yourself, through increasing copays for drugs and higher office visit coinsurance. The consumer of health care is sharing more of the cost and thinking twice about utilization as a result. It is becoming more discretionary in nature.

Over time, this should increase efficiency and help shrink the growth in health care spending. In the near term, demand will shrink or be shifted from some products and services to others. I believe this effect is exacerbated now as a result of the struggling economic situation in the U.S.

6. Growth? Each of the major pharma companies has at least one major patent expiry in the next few years. Are these companies able to navigate the challenges of losing a large piece of revenue? I just don't know at this point.

In my opinion, there is only one reason you might still be interested: valuation. These stocks are trading like bonds -- many of them with mid- to high-single-digit dividend yields -- and they are trading at a reasonably large discount to the S&P 500 index, which trades at more than 15 times this year's earnings estimates with only a 2% yield.

Here's a list of the major drugmakers, ranked by dividend yield compared to the S&P 500:

Company	Ticker	Price	Yield	P/E
Pfizer	PFE	17.72	7.2%	7.5 times
AstraZeneca	AZN	40.85	6.6%	8.9 times
Bristol Myers Squibb	BMY	20.03	6.2%	12.1 times
Sanofi-Aventis	SNY	32.56	5.0%	7.9 times
GlaxoSmithKline	GSK	42.12	4.8%	10.8 times
Merck	MRK	34.68	4.3%	10.5 times
Eli Lilly	LLY	47.78	3.9%	12.2 times
Novartis	NVS	49.83	3.0%	13.8 times
Johnson & Johnson	JNJ	65.59	2.8%	14.7 times
Abbott Laboratories	ABT	53.57	2.7%	16.6 times
Wyeth	WYE	45.16	2.6%	13.1 times
Schering-Plough	SGP	19.26	1.4%	12.7 times
S&P 500	SPX	1350.93	2.0%	15.7 times

These issues surrounding big-cap pharma keep many marginal buyers on the sidelines. In addition, I believe that many of the shareholders of these "value" stocks also hold or held many of the dividend-yielding banking stocks that have been eviscerated over the last year. These investors have likely been repositioning their portfolios by selling what had become an overweight pharmaceutical position.

I believe we'll need a real catalyst to get people to buy these names again -- or at least stop the selling. Maybe it will be a Bristol Myers Squibb (BMY - commentary - Cramer's Take) acquisition. Or a major, transformative restructuring out of Pfizer (PFE - commentary - Cramer's Take). I think valuations are compelling enough to start to wade into these stocks and get paid dividends to wait before making a larger bet on the group. We may see a glimpse of what is to come on the second-quarter earnings releases, so keep your eyes open and do some research of your own.

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At the time of publication, Ferayorni was long Pfizer, Johnson & Johnson, Wyeth, Merck and Bristol Myers Squibb and was short Abbott Labs, although positions may change at any time.

Justin Ferayorni, CFA, is the founder and principal of Tamarack Capital Management and was an analyst and portfolio manager at Bricoleur Capital. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ferayorni appreciates your feedback; click here to send him an email.