Skip to main content

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) - Get Free Report

, 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.


(PFE) - Get Free 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) - Get Free Report

yields 1.2%. The

Merrill Lynch Pharmaceutical HOLDRs Trust

(PPH) - Get Free Report

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.


So the yields are in the same ballpark, and both TIPS and pharmaceuticals have limited upside.

What about the downside for health? This idea would make no sense if Pfizer and


(MRK) - Get Free Report

plummet from here.

But here is an anecdote that may point to a bottom. When I first wrote about my Pfizer revenue theory a year and a half ago on another Web site, I received an incredible amount of hate email. When I repeated the idea in a

Columnist Conversation post

last week, I only got one email that mildly disagreed. This leads me to think the selling could be about done.

Three things might be enough to tie this theory together: similar yield, limited upside and limited downside.

If the broad market provides below-average returns for the next few years, as some contend, and if my thoughts about pharmaceuticals hold water, it might result in the pharmaceutical-centric ETFs averaging 2%-3% returns plus the dividend. That's not much different from what TIPS are likely to do.

But pharma ETFs offer something TIPS don't. Despite what anyone thinks about the fundamentals, the entire sector could rally significantly at any time for no reason at all. This has happened repeatedly throughout market history. Pharma-centric ETFs should participate to some degree in a broad market rally -- this can not be expected of TIPS.

This idea makes some sense if you believe that, after being cut in half or worse, domestic pharma stocks have now seen most of the selling.

At the time of publication, Nusbaum was long JNJ, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

click here

to send him an email.