Any investor believing that fundamental changes in the markets could lead to a big breakout for long-dormant giant drugmakers should think again, even with this week's rally. This is a presidential election year, when drug stocks don't typically do very well thanks to political debates about the cost and access of health care. Throw in a legislative push to import cheaper drugs from Canada and you have all the makings of an uncertain investing environment, no matter how much cost-cutting and molecule-discovering the companies achieve. And even though conventional wisdom might say that drug stocks are something of a safe haven when interest rates are on the rise, analysts and strategists alike are cautious about the sector's somewhat uncertain prospects. "You can't be a market-timer," said Elizabeth Bernstein, an equities analyst at Morningstar who follows drug companies. "You might not see improvement until after the election." Despite that advice, investors have spent the past two days rotating money into pharmaceuticals shares, worried about the potential impact of higher interest rates on other sectors. On Thursday, with the Dow spending most of the day in the red before crawling out in the last hour, the Amex Pharmaceutical Index tacked on a 3.5% gain, bringing its two-day runup to 4.3%. Merck ( MRK), Pfizer ( PFE), Johnson & Johnson ( JNJ) and Eli Lilly ( LLY) were all up more than 3% Thursday. No doubt, drugs can provide a cushion during bad times. For the four years ending Dec. 31, 2003, the total return -- price appreciation plus reinvestment of dividends - for the S&P 500 Index was a minus 19.7%. For the Amex Pharmaceutical Index of 15 large companies, the total return was 2.53%. But enough drug stocks failed to equal the broader market's big gains in 2003. Right now, the best that could be said about the big drug players is that they are doing less bad over the last four weeks than over the last 52 weeks when compared with the S&P 500. For the 52 weeks ended April 14, stocks in the S&P 500 had a total return of 29.7% while the Amex Pharmaceutical Index gained 8.8%. For the four weeks ended April 14, the S&P 500 was up 2.24%, while the Amex Pharmaceutical index rose 1.39%.
As in any sector, investors must be selective. Eli Lilly looked good over the past 52 weeks with its 20.8% total return. But in the last four weeks, Lilly's return was only 1.05%, below the Amex Pharmaceutical Index's gain. Pfizer was among an above-average drug performer for 52 weeks (up 13.6%) and for four weeks (up 2.46%). Johnson & Johnson performed poorly over 52 weeks (down 7.3%) but did well recently (up 4%), thanks partly to its earnings surprise. And Merck managed to underperform its peer group over the long term (down 12.7%) as well as the short term (up 1.32%) and remains relatively close to its 52-week low. "Our research shows there are no indications based on the last 13 weeks or the last 52 weeks that Big Pharma is picking up," said Trip Jones, managing director of SunGard Institutional Brokerage. Jones looks at relative stock price performance among industry groups, examining not only stock price momentum but also the rate of stock price changes. Considering that his firm is predicting a stock market correction of 10% to 15% though the summer, Jones recommends that customers be defensive by picking "big-cap, big-yield companies," which could include drugmakers. But Jones says investors must be aware of politics. He fears that if Congress passes, and President Bush signs, legislation allowing the importation of less-costly drugs from Canada, then big drug companies will take a big beating. "Political pressure presents a real pricing problem," he said. "It will be a real margin problem." Perceptions about the role of drug companies in the marketplace mystify and anger Neil Sweig, who follows the industry for Fulcrum Global Partners. "Why has this stock group become such a cause celebre?" he asked in a recent report to clients. Comparing the health care and drug industries against other sectors of the S&P 500, Sweig found a mixed picture when looking at predicted earnings-per-share growth.
The S&P 500 index is expected to grow 12% this year. The total health care universe -- drugs, hospital supplies, biotech, etc. -- is expected to grow 13.3%, or fourth best among 10 broad S&P sectors. But the pharmaceutical component was expected to achieve 10.9% EPS. Still, that's better than sectors such as telecommunications service, utilities, energy and consumer staples. By 2005, Sweig's research projects the S&P 500 Index EPS growth rate slowing to 9.5%, while the health care-sector EPS-growth rate would be 13.6% --fifth among the 10 broad categories -- while the drug component EPS growth rate would move up by 11.7%. Sweig said the industry is being trampled by politics. "It seems that too many states have announced regulatory investigations of drug companies for possible pricing violations, as well as for questionable market/promotion activities," he said. "When will these states stop using the pharma industry to fill their empty treasuries?" Sweig said the "heated and nasty" presidential election will have a profound impact on the industry. If President Bush "looks like the winner from the third-quarter polls, then our drug group may be rewarded as facing the less difficult situation in 2005." He didn't predict what would happen if the Democratic front-runner Sen. John Kerry won the election. But remarking that Kerry "appears to never have anything positive or neutral to say" about the industry is probably all investors need to know about Sweig's sentiments. Politics also affects the view of the drug-stock world of Elizabeth Bernstein, of Morningstar, who says presidential elections historically provoke declines among drug-company stocks and unease among drug-company investors. Even tangible events don't always present a clear picture. The recent Medicare drug law, for example, could bother investors because companies' profit margins will decline due to government payment guidelines; but the law could encourage investors because companies will gain access to more customers. Overall, the legislation is probably a wash for investors, Bernstein said. Bernstein said the prospect of higher interest rates won't affect big drug companies directly because their capital structure -- they have less debt than manufacturing companies -- allows them to better-absorb the impact of interest rate hikes. Indirectly, that financial structure could make drug companies look good in comparison to manufacturers or companies making big-ticket consumer goods. "If rates go up, you might not buy that TV, but you will still buy drugs," she said.