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A Better Way to Play Pharma

This column was originally published on RealMoney on Nov. 8 at 8:07 a.m. EST. It's being republished as a bonus for readers.

Over the past few weeks, I have heard a couple of different analysts refer to big domestic pharma stocks as bonds, and that got me to thinking. The idea of a drug stock as a proxy for a bond doesn't hold up very long, but perhaps the higher-yielding drug stocks could be a proxy for Treasury inflation-protected securities, or TIPS. But how do these match up against pharma ETFs as a way to play the sector? Let's take a look.

I maintain very little exposure to big American pharma -- clients own Johnson & Johnson (JNJ), but that's it. And I invest in overseas drug companies in the context of foreign diversification.

The problem I see with American drug companies is that they have poor prospects for double-digit revenue growth. Pfizer (PFE - Get Report) has about $52 billion in revenue. Consensus for 2006 is no revenue growth. Will it be able to find $5 billion in new revenue for 2007? If it does, will it then be able to find $6 billion in 2008? I don't see how it can. If it can't, it's reasonable to believe the stock will idle, assuming no death-blow news to one of its drugs.

My expectations for price appreciation for the big domestic drug companies are very low. TIPS also have quite low chances for price appreciation (their par value inches up at the rate of inflation, and they pay an interest rate that is usually lower than that of regular bonds), so there's one thing they have in common.

The drug-stock-as-bond comments that I heard referred to individual stocks. Bondholders don't usually take on single-stock risk, so for me, a stock doesn't quite hold up as a bond substitute.

The drug sector ETFs might be a different story. Clearly, any product that reasonably diversifies its holdings won't have substantial single-stock risk.

A five-year TIPS yields about 1.8%. The Healthcare Select Sector SPDR (XLV) yields 1.2%. The Merrill Lynch Pharmaceutical HOLDRs Trust (PPH) yields 2.5%.

Hard Times in Pharmaceuticals
Merck and Pfizer have dropped significantly over the past few years; pharma ETFs have held up better.
Click here for larger image.
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