Tech-Free Friday: Drugs Are the Love Some Are Thinking Of

Once investors sense that a rebound in the economy could still be a while off, pharmaceutical stocks should again find favor in the market.

For a long time, drug stocks were the antitech, climbing as the Nasdaq fell. The reason was simple: Sales of pharmaceutical products show little sensitivity to the ups and downs of the economy -- even in a recession, people care about their health. Moreover, because of the tremendous costs involved in developing and marketing new drugs, the chances of new competition entering the fray are small.

That's added up to steady earnings growth for the drug companies, regardless of where we are in the economic cycle. Because of this, whenever the economy looks like it's going to hit the skids, investors move into big pharma.

Backing Off

Since the year began, however, it's been a different story for the pharmaceutical stocks. When the Federal Reserve first cut rates on Jan. 3, many investors surmised that a rebound in economic growth was in the offing. With many forecasters reckoning on a V-shaped recovery, it seemed like a good idea to start clearing out of the drug stocks and buying cyclical areas, like retailers and capital goods makers, that would see earnings growth reaccelerate. Drug stocks fell sharply, and, even though the rally in cyclical has faded, they continue to perform poorly. The S&P 500 Major Pharmaceuticals sector has fallen 21% this year, giving back more than three-quarters of the gains it made last year.

Rock Steady S&P pharmaceutical sector earnings

Source: Baseline. 2001 figures estimated.

This year's early rally in cyclical stocks faded for a reason -- it looks as though the economy is not going to put on that V-shaped recovery so many had hoped for, but a longer, U-shaped one. Weakness in capital spending, the knock-on effects of the trouble in the technology sector (which had, until this year, been accounting for about a percentage point of GDP growth) and high energy prices are bearing down on the economy. Meanwhile, with both income and wealth under pressure, the consumer looks to be on shaky ground. Many economists now expect the economy to remain mired until at least the third quarter. And where the economy goes, so go U.S. corporate earnings.

"We're not yet into the bottom of the valley on profits," says Morgan Stanley Dean Witter chief U.S. economist Richard Berner. "We've got a way to go here."

Contrarians

But while the overall U.S. profits picture looks bad, analysts expect earnings in the S&P 500 pharmaceuticals to grow 15% in 2001. And although analysts in other industries have been steadily chopping estimates, five of the seven drug companies in the S&P have seen 2001 estimates raised during the past three months.

"Drug stocks have tended to do well in the past when they've grown earnings faster than the market," says J.P. Morgan Chase equity strategist Tom Van Leuven. "That's going to be true at least for this year and possibly into next year. We also think it's in the right part of the broad consumers goods and services sector of the market -- the consumer staples area that people are dedicating more of their spending to."

J.P. Morgan Chase's equity strategy group has also found an inverse relationship between industrial commodity prices and drug stock performance, which makes sense when you consider that rising commodity prices signal a rebound in the economy. Commodity prices are still falling.

If there is a chink in the argument for drug stock outperformance, it's that with an average price-to-earnings ratio of 29.8, some view it as expensive. "The bear case is that valuations are too steep and need to come down, especially in light of ongoing regulatory risk," says Charles Crane, market strategist at Spears Benzak Salomon & Farrell, which remains underweight the sector.

Such regulatory worries may prove overblown -- the Medicare prescription benefit plan that the Senate Finance Committee is using as its starting point would be far more palatable to the drug companies than the ones that were getting bandied about during the election. On the valuation front, yes, the drug sector is more pricey than the S&P, but P/Es aren't out of line with where they've been for the past three years or so.

To that, add that even in a slumping economy, you are never going to hear management complain about how they have no "visibility" into the future, and it seems quite possible that an increasing number of investors could soon take comfort in drugs.