New Year, New Rules: Drugs Sounding Good to Investors About Now

The economy may slump and the market may plunge, but investors can always feel safe with the health care stocks.

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At least that's the hopeful view of sell-side analysts and fund managers who hold the stocks. And there's good evidence that over the next year, drug stocks and their riskier biotech brethren will likely outperform cyclical stocks, representing something of a safer haven for investor money.

The thinking is this: You may put off buying a new car, house or computer when the economy gets rough, but you're not likely to stop taking blood-pressure medicine, antidepressants or pain killers. And your company may skimp on capital spending, but it won't let you to die on the job, ensuring your health care benefits.

There are plenty of drugs in development, as drug makers everywhere try to find treatment for diseases that afflict millions, looking to reap the stratospheric profits that can go to a popular new drug like Pharmacia's (PHA Quote) Celebrex for arthritis. Furthermore, prices for new medicines, while high, appear mostly sustainable, since insurance companies and health care providers have demonstrated a willingness to avoid the far more expensive course, hospitalization.

"The need for new medicines is not going away," says Karen Hanley, analyst with the Robertson Stephens New Opportunities fund, a new biotech fund. "The population is aging and we need new drugs for all kinds of diseases, such as cancer and age-related illnesses."

Stores of Value

That view has been reflected in stock performances this year. While the tech-heavy Nasdaq is sharply off its highs, the Nasdaq Biotech Index has mostly had a great year, with biotech stocks up nearly 50% from a year ago. The biotech index outperformed other major indices, like the Dow and the S&P 500, which are now trading mostly flat from a year ago.

Turnaround Drug stocks outperforming tech

And the Amex Drug Index, which includes major drug stocks, is up some 25% from a year ago, pushed by investors seeking the much-discussed safe havens after a tech stock rout prompted by warnings from outfits like Lucent (LU Quote), Intel (INTC Quote) and Apple (AAPL Quote).

The macro forces that could hurt the industry, such as a national health insurance program, have been seriously hobbled now that Republicans have taken control of Congress and the presidency. Hence, any program to cover drug costs for the elderly will be decidedly more industry-friendly, managed by private companies rather than by a government agency, observers believe. That means any promised program will threaten industry profits with only a marginal hit, if indeed anything at all gets done in a sharply divided Congress.

"We think there will potentially be legislative gridlock," says Beth Cariello, drug analyst with Deutsche Bank, who has an overweight rating on drug stocks. She previously forecast a 1% to 2% earnings hit for the industry on the imposition of a national health care program with price controls. Now, she says, "either nothing will get done, or what gets done won't be onerous." Cariello believes drug sector investments are likely to perform better than other sectors next year.

Excuses, Excuses

If anything, analysts say a national health care program could be good for the industry, since it will expand the use of drugs among the 20 million or so people who aren't covered by any outpatient program. Even if price controls are imposed, higher volumes will more than cover the cost to the industry, they say.

But the bulk of the industry expansion will likely come from new drugs, and there are many in development. As of June, the U.S. biotechnology industry alone had 283 products in mid-to-late stage clinical development, calculates Goldman Sachs, many in partnership with leading drug companies that collectively have dozens of their own in advanced development.

The downside, of course, is that many of these high-risk drugs won't make it to market, and the results of a failure can be devastating for big and small companies alike.

Among the highest profile failures this year was Vanlev, expected to be a multibillion-dollar selling hypertension drug that was sent back for more tests at Bristol-Myers Squibb (BMY Quote), and Maxim Pharmaceuticals' (MAXM Quote) cancer drug Maxamine, which was rejected by the Food and Drug Administration last week. Both moves led to sharp stock price declines.

And certainly patent expirations are keen on the minds of investors, particularly for companies like Merck (MRK Quote), which is facing patent expirations on some $5 billion worth of sales in the next four years. With robust numbers from drugs like Vioxx for arthritis and Zocor for cholesterol and a bevy of new successor drugs, Merck says it can ride out the expiration loss and continue to generate strong earnings.

"In 2001 to 2002, we expect new product visibility to noticeably improve, with the major therapeutic success stories emanating from the Cox-2 inhibitors [like Vioxx] and their next-generation brethren, the cholesterol-lowering drugs, drugs for hypertension and congestive heart failure and biologicals, including new drugs for sepsis and rheumatoid arthritis," wrote Morgan Stanley Dean Witter in a recent report.

Value Talk

The risk, of course, is that drug stock valuations may get well beyond what investors will pay, but that concern may be offset by a relative lack of opportunity in other sectors for a safe earnings stream, writes Morgan Stanley:

"Changing hands at a 40% to 50% premium to the broad market, U.S. drug stocks are trading at valuations well ahead of their historic ranges of 25% to 35%. However, if we move into an environment with steeply falling earnings in the broader market, combined with pockets of modest upside surprise in the drug sector, then we believe the group remains attractively priced."

But if you think drug stocks are a buy at any price, try biotech stocks, where prices can hover around 70 times forward earnings (when there are any). And there's lots out there to be had, with lockups coming off many of the 50-plus initial public offerings this year, with at least 20 lockups expiring in January alone, according to unlockdates.com, a Web site that tracks such matters.

Still, the IPO and stock offering boom this year gave biotechs the means to make the new drugs that will drive the growth in the future, whether it be from risky genome plays to more solid therapeutic drug stock picks. For some analysts, this was a watershed year, where more and more biotechs are starting to turn a profit and demonstrate that biotech is nowhere near dot-com land, as Barron's recently suggested.

"The biotech model is finally getting proven, with lots of drugs before the FDA and more companies getting profitable," says Stefan Loren, analyst with Legg Mason Wood Walker. "We are looking at a favorable outlook for next year."