This was originally published on RealMoney. It is being republished as a bonus for readers.

We've all heard the bullish case for drug stocks. Demand for pharmaceuticals and medical supplies will keep growing as the U.S. population ages and we live longer. The thesis has been spot on for a long time: health care spending has risen 25% faster than the economy for the past 50 years.

Now the story has hit a formidable roadblock. The Food and Drug Administration (FDA) is standing in the way of drugmakers and impeding sales and profit growth for drug companies. In the wake of the Vioxx disaster of 2004, the number of new drugs approved by the FDA has shrunk dramatically. In 2007, the agency approved only 19 new drugs. The FDA is also being much more aggressive in monitoring existing drugs and issuing far more warning letters about potential side effects.

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The industry has been battling back by increasing its lobbying budget, asking legislators to speed up the approval process, help in blocking the importation of cheaper foreign drugs, and patent extensions to protect against domestic generic competition.

Industry leader


(MRK) - Get Report

has been among the hardest hit by the FDA's tougher approach. The company has had two major setbacks this year.

First, it recently received a non-approval letter for a new cholesterol drug, Cordaptive. This follows a finding that its Vytorin cholesterol medication was less effective in preventing heart disease than cheaper competing drugs.

Many analysts now question the strength of the company's new drug pipeline and its ability to gain approvals. The concerns have hit the stock hard with the shares down 50% from their highs.


(PFE) - Get Report

has a different problem. Over half the company's drug portfolio comes off patent protection over the next three years, so the company needs to get new drugs into the product mix to replace the lost revenues. Pfizer has boosted R&D spending at the expense of the balance sheet. Short-term debt has risen 50% to $9 billion in the last year.

The drug companies are increasingly turning to more lenient marketplaces to generate profits. The European drug agencies have approved twice as many new drugs in recent years. Emerging markets are also playing a bigger role in the plans for major drug companies.

There is also less competition from generic manufacturers in foreign markets, and far fewer pricing constraints form regulators and insurance companies. For now, the strategy is working aided by a weak dollar. Pfizer and


(MRK) - Get Report

both reported large foreign exchange profits in the second quarter. It remains to be seen how the strategy plays out on a long term basis.

With the major companies suffering from a weak pipeline and pricing concerns, I think the real play in drug stocks is the generic drug companies. As drugs come off-patent, brand name and recognition become far less important.

Increasingly, consumers care about the results, not the brand name on the drugs they need. Virtually every insurance prescription plan encourages, and in some cases, mandates the use of generic drugs when they are available.

The best choice in generic drug companies for my money is


(MYL) - Get Report

. The company is well positioned with over 130 generic drug products currently on the market.

Mylan also has over 80 generic drugs awaiting approval by the FDA. Twenty of these are first-to-file, which means that if approved, Mylan will have a jump over competitors by offering the only generic substitute for a period of time. The company intends to compete in foreign markets as well. It recently bought Merck's generic division and is using it to expand into Europe and Asia. Insiders at the company seem to agree with me, having purchased over 86,000 shares in recent months.

The major pharmaceutical companies are facing difficult operating conditions right now. Institutional investors have noticed as well, with funds picking up over 35 million shares so far this year.

Tough times are likely to continue for the major pharmaceutical companies. They are focusing on cost-cutting rather than expansion. Some of them, notably Pfizer, may have trouble continuing their dividend levels. I would not own them even at depressed prices. If they were to rally I would short them, with Pfizer and Merck being my top picks to decline.

I would own Mylan however. There is a continual stream of drugs coming off patent, and Mylan has the expertise and marketplace experience to benefit for years to come.

This was originally published on


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At the time of publication, Melvin had no positions in the stocks mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback;

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