The Case for Drug Stocks

You don't need to be a doctor or an economist to know that rising interest rates have been something of a tonic for Big Pharma. And you also don't need to be a mutual fund portfolio manager to know that the rise in drug stocks is making health care fund managers feel better.

The nearly indistinguishable one-month charts plotting the rising yield on the 10-year Treasury note and the Amex Pharmaceutical Index(DRG Quote) shows the tight connection between rising rates and drug stock performance. Both benchmarks bottomed out in late March, with the yield on the 10-year Treasury dropping to 3.67% on March 24, and then rocketing up to its recent range around the 4.40% level. Over the same period, the pharma index rose 4.5% vs. only 3.2% for the S&P 500.

Since diversified health care funds have their heaviest weightings in large-cap drug stocks (on average between 40% to 60%), the rise in Big Pharma also powered health care funds toward the best one-month performance of any category of domestic equity funds, rising 2.37%, according to Morningstar.

"Historically, when the Fed begins to raise rates, the pharma stocks are relative outperformers," says David Moscowitz, analyst at Friedman Billings Ramsey. (To see a contrarian view on this topic published last week, click here .)

Perhaps the best example of the historical link between rates and drug stocks took place in 1994-95 when the Fed aggressively raised overnight lending rates from 3% to 6% in about a year's time. During that period, the pharma index rose over 25% compared to a mere 2% gain for the S&P 500.

Albert Rauch, analyst at AG Edwards, says drug stocks become popular during a rising interest rate environment because they trade independently of the economic cycle. Unlike housing, auto and financial stocks, which can be whipsawed by interest rate moves by the Fed, drug stocks are far less sensitive to rate increases, partly because the industry carries a lighter debt load.

Checking Up on Health Care Funds (Returns through 4/15/04)
Fund	Ticker	YTD	3 Years	5 Years	Expense Ratio
Eaton Vance Worldwide Health Sciences	ETHSX	4.41%	4.06%	18.14%	1.97%
Evergreen Health Care	EHCYX	6.25	15.79	-	1.75
Munder Healthcare	MFHYX	10.86	4.61	20.09	1.89
Fidelity Select Health Care	FSPHX	6.03	-	-	0.99
State Street Research Health Sciences	SHSSX	8.64	18.48	-	1.25
T. Rowe Price Health Sciences	PRHSX	10.03	10.06	11.96	1.00
Vanguard Health Care	VGHCX	3.93	7.47	13.03	0.28
Amex Pharmaceutical Index	^DRG	-2.4	-13.9	-16.5	-
S&P 500	SPX	1.95	-0.07	-1.76	-
Source: Morningstar