Can Derivatives Cure Drug Stocks?

The Celebrex trapdoor that has opened beneath Pfizer (PFE Quote), coming less than three months after Vioxx administered a similar clobbering to Merck (MRK Quote), highlights an industry with structural troubles.

It would be too easy to cast stones at Big Pharma, to call these companies greedy or avaricious or simply careless in their testing and development. We could argue all day and into the night whether the industry spends too much on advertising or is too focused on patent extension and the development of me-too drugs.

So let's not. Instead, let's engage in a few thought experiments about the nature and structure of this industry and those similarly situated.

First, let's remember this sector's importance to us as investors. The S&P Pharmaceutical index is the largest of the 132 index groups comprising the S&P 500. It accounts for 6.879% of the market's capitalization, so given the prevalence of indexation strategies, it is highly likely that you own these firms in one form or another.

The pharmaceutical industry is a far riskier investment than the broad market as a whole, as defined by its distribution of returns since the Dec. 29, 2000, inception of the current S&P Pharmaceutical index.

It has both a wider distribution of returns and a greater-than-expected incidence of extreme returns than the broad market does. It is also more skewed toward large negative values. Its coefficient of skewness is (0.1257) as opposed to (0.10433) for the S&P 500. This distribution of returns defines the problem for investors: Risky assets are worth less to many. A solution is proposed later.

Distribution of Returns: S&P Pharmaceutical Index vs. S&P 500

Source: Bloomberg

Second, the pharmaceutical industry is as much of an intellectual property business as software and entertainment are. Just as the first copy of a new operating system costs hundreds of millions of dollars to design and test and the second copy costs about 15 cents to stamp out on a CD, pharmaceutical firms have massive initial fixed costs and minuscule variable costs of production. While their products are not stolen and counterfeited as often as software or music, they face myriad global price controls, third-party payer policies and regulations.