Considering the hyperactive nature of the stock market lately, you'd think every portfolio manager in America would be taking his meds. But the drug sector has in the past few years become the most underowned and neglected on the board, as one calamity after another has surfaced to sap investors' perceptions of pharmaceutical makers' strength.
Public enemy No. 1 for shareholders of Big Pharma, and in the past 12 months in particular, has been a Medicare reform bill wending its way through Congress. Pessimists have feared that the large companies already beset by depleted new-product pipelines and price competition from generic varieties of their top-shelf drugs would face new rivalry from low-cost foreign imports, as well as margin pressure from government-program warlords.
As a result, by the start of last week, the three biggest pharmaceutical makers --
-- were valued by the market like bonds: Their valuations implied that their coupon, or dividend, was their only valuable asset. They were getting virtually no credit for potential growth -- a loopy situation for a group that has consistently posted annual earnings improvements of 7% to 12% in good times and bad.
Now comes word out of Washington that maybe the legislation known officially as H.R. 2473 -- the Medicare Prescription Drug and Modernization Act of 2003 -- might not end up so badly for drugmakers after all. It is one huge pile of paper, very complex and far from finalized. But it appears that some of the most antibusiness elements of the bill -- you could also say pro-consumer -- have magically disappeared in the latest iteration to emerge from a House-Senate conference committee.
Why the Drug Rally Is for Real
The suddenly real prospect of federal expenditure of $400 billion on drugs over the next 10 years got investors' attention. It was good for a 6% advance in the Amex Pharmaceutical Index (DRG) last week in a market that hated everything else.
Laggards Merck and
rose from long-term ruts, while more highly regarded
hit one-year highs that were still well off their all-time bests.
In all likelihood, the move will have legs. The drug group was already ridiculously cheap -- by some metrics, the stocks have not been more crushed since the Clinton health care reform fiasco of the early 1990s -- and has just needed a catalyst. Barbara A. Ryan, drug analyst at Deutsche Bank and elsewhere over the past 21 years, drew a parallel to those sick days in a report published Thursday just before the rally.
"Sentiment is as bad as it gets, all the negatives are readily recited by every client I meet, no one admits to owning the group, and no one can think of a positive reason to buy them," she wrote. "Sounds like a bottom to me!"
Merck advanced 500% in six years after its 1993 reform-fear low -- a time when, like now, the drugmaker's cupboard of new products was considered bare -- while Schering gained 700% and Pfizer gained 800%. No one, not even Ryan, is forecasting gains like that for these stocks going forward. But these shares could certainly capture some momentum rotating over from listless tech and retail stocks that are trading at peak valuations, particularly if drugmakers match expectations for 13% earnings growth in 2004 while cyclical companies, such as semiconductor makers, struggle with harder year-over-year comparisons.
Checking Up on the Medicare Bill
Because the Medicare bill is the key catalyst, let's see where it stands now, and its potential effects.
First, some background. Medicare is a federal medical insurance program for people 65 and older. (If you qualify for Social Security benefits, you automatically qualify for Medicare.) Like a private insurance program, it covers medical costs after deductibles are met. It does not pay for outpatient prescription drugs, and that is why the reform bill has become a lightning rod for disagreement between Republicans and Democrats over the role government should play in providing health care.
While Congress has budgeted $400 billion to pay for the drug benefit over a decade, the Congressional Budget Office estimates it actually will lead to $1.8 trillion in drug charges for Medicare beneficiaries over that time. The bill, which could still change substantially by the time it comes up for scheduled House and Senate votes next week, looks like this, according to analyst and news reports:
Drug benefit. Starting in 2006, the government and senior citizens would split costs 75/25 for up to $2,200 a year after a $275 deductible and a $35 monthly premium. The beneficiary would pay the full amount from that level up to $3,600 or $5,200 (the amount is in dispute). After that, the government would pay 95% of the cost. Subsidies would be available to low-income seniors.
Delivery. The drug benefit would be offered through private insurance plans, but if there aren't two to choose from in your area, the government will step in and provide it.
Employer incentives. The bill would offer $16 billion to $18 billion over 10 years to employers that offer drugs benefits to retirees with unusually high-cost needs.
Drug importation. This has been one of the most controversial aspects of the bill. As originally proposed, seniors would have been able to purchase lower-cost drugs from Canada. The current bill would allow reimportation of drugs from Canada only if the Health and Human Services Department certifies their safety -- but a final version may nix even this watered-down version.
Premium support, or privatization. This is where Republicans and Democrats clash most. The GOP wants Medicare to start competing with private health care plans in 2010, but a compromise would instead create a three-year demonstration project in a small number of areas around the country. Democrats, led by Sen. Edward Kennedy (D., Mass.), oppose this plan and have threatened to filibuster the bill if it's included in the final legislation.
HMOs and PPOs. The government would create a $12 billion fund to help draw more preferred-provider and health maintenance organizations into the Medicare system. This is a heartthrob of GOP conservatives who wish to generate strong private competition to the government program. Smith Barney analyst Charles Boorady estimates that this could mean an additional 8 cents in earnings per share to PacifiCare Health Systems in 2004, and 1 cent to Humana .
Hospitals. Rural hospitals are expected to be big winners, as they would start getting urban rates for health care costs starting in April and would benefit from side deals on changes in regulated wage rates. Urban hospitals, meanwhile, could benefit from a clause in the plan that would place a moratorium on the construction or expansion of specialty surgical centers.
Horse trading on the bill will be intense this week as the Republican majority scrounges for votes to give President Bush a major legislative win, while Democrats ponder whether they would score more points for the 2004 election season by going along or blocking it. Several veteran analysts give the legislation only 50/50 odds of passing.
Bill Would Be Good for the Street
If there were a senator from the great state of Wall Street, you can bet he or she would be voting in the affirmative. The bill would disperse a cloud of uncertainty that has hung over the health care sector for more than a year, and increases in the volume of drug sales are expected to outweigh government-induced pricing pressures.
How much volume? Smith Barney reports that Medicare beneficiaries with drug coverage used 32 prescriptions per person per year, while those without drug coverage used just 25. If the 10 million individuals at whom the law is aimed increased their drug use by seven prescriptions per year, the increase in volume would be north of 70 million per year.
The benefit to drugmakers depends on the extent to which managed-care companies and the government are able to extract significant discounts. Smith Barney estimates that if discounts of 15% are achieved, the annual increase in drug sales could ultimately be less than $2 billion, and if discounts go as high as 22%, as some have suggested, the entire benefit to drugmakers could be negated.
If these uncertainties were coming at a time when drugmakers' stocks were at highs, the benefits would be uncertain. But with share prices historically low and sentiment negative, it seems as if passage of the bill could be just the shot of adrenaline the big pharmaceutical companies need to catch up with the broad market and, perhaps, surpass it in the year to come. Top choices are listed in the table above.
Jon D. Markman is publisher of
StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at
email@example.com. At the time of publication, Markman controlled accounts that were long the following securities mentioned in this column: Merck and Wyeth.