An outbreak of Big Pharma flu has struck the generic-drug industry, causing sickening returns for investors who had been counting on these defensive investments during economic uncertainty.

Shares of most major generic-drugmakers have traded below the S&P 500 for the 12 months ended May 23, and that index was off nearly 10%.

In addition, several generic-drug makers have performed below an index of large-drug companies, and that's a big target to miss. The Amex Pharmaceutical Index is down 19%.

Among the prominent players, the exception to the malaise is Teva Pharmaceutical Industries ( TEVA), the world's largest generic-drug company. Teva's shares are up 13% for the past 12 months. Its market capitalization of $35 billion is nearly triple the combined market caps of other independent competitors cited in this article.

The world's second largest generic-drugmaker is the Sandoz division of Novartis ( NVS).

Although the generic-drugs business is an intense, commodity-like affair, current economic conditions and today's drug-industry environment should, in theory, prompt cheers from investors in the group.

Major brand-name drugs keep losing patent protection, and an expensive flood of patent expirations should occur during the 2010-2012 period. A U.S. Supreme Court ruling last year on patent-protection in a nonpharmaceutical case could help the generic-drug industry by making it easier for generic-drug makers to challenge certain patents.

Meanwhile, managed care firms keep pressuring doctors and consumers to choose generics over brand-name drugs. The eroding economy has reinforced consumers' efforts to save money on medications.

So, why is Mylan ( MYL) down 37.5% over the last 12 months? Why has Barr Pharmaceuticals ( BRL) fallen by 21%?

What's wrong with Par Pharmaceutical ( PRX), whose stock is off 36%? And why has Watson Pharmaceuticals ( WPI) tumbled by 8.5%?

Many of these 12-month results aren't aberrations. Over the last 24 months, shares of Barr, Mylan and Par fared worse than the S&P 500 and the Amex pharmaceutical index. Watson is is slightly ahead of the S&P 500 and better than the Big Pharma index. Teva surpasses all of them.

Reasons for a Slump

There's no common theme for these sagging stocks, says Brian Laegeler of the independent research firm Morningstar. For Mylan, whose market cap is $3.8 billion, and Barr, whose market cap is $4.6 billion, the stock weakness is tied in part to integrating big acquisitions made in 2006.

"Both were playing catch-up with Teva in size and in establishing a presence in Europe," he says. "Overall, they were taking positive actions."

Shaking off the dilutive effects of their acquisitions and reducing deal-related debt will take some time. "I look for good years for Barr and Mylan in 2009 and 2010," he says.

The biggest drag on Watson's stock was recently removed when the Food and Drug Administration said problems at a manufacturing plant had been fixed. The Florida plant belonged to Andrx, a rival acquired by Watson in 2006. Watson, which now has a market cap of around $3 billion, knew about the problems. Until the FDA gave its approval, the agency had refused to approve new drugs that would be made there.

Laegeler says Par is in the midst of a risky strategy of expanding its development of brand-name drugs. These products have higher profit margins than do generics, but they're more expensive to make and market.

With a market cap of $634 million, Par is making a decision that is creating uncertainty in the minds of investors and analysts. Thomson Reuters reports five analysts are neutral and one has a sell rating.

Teva, Barr and Watson make some brand-name drugs; Mylan tried to do so, but it has decided to focus on generics. Sell-side analysts support Teva, and they still like Barr and Mylan. Thomson Reuters says each company has more buy ratings than the combined neutral and sell ratings. Watson has few buy ratings, with most analysts neutral.

Morningstar assigns its top, 5-star rating for Barr, Mylan and Watson. Based on their fundamentals, they are trading so far below their fair values that Laegeler says they're worth buying. Teva earns four stars, and Par gets two.

Forecasting a Comback

For investors with short-term outlooks, Barr has been the biggest disappointment. Its stock plunged from $49.65 on May 7 to $38.10 the next day after Barr issued first-quarter results that fell below expectations and lowered its full-year earnings forecast.

Barr blamed weaker U.S. generic results, higher R&D expenses and under-performance by Plan B, the emergency contraception pill. Barr promised the second half of 2008 would be better.

Merrill Lynch and Goldman Sachs cut their ratings to neutral from buy, and Zacks Investment Research dropped its rating to sell from hold. However, S.G. Cowen raised its rating to outperform from market perform.

The negative reviews ranged from criticizing the lack of short-term revenue opportunities to Goldman Sachs' complaint about Barr's ability "to drive value from Pliva," the Croatian company it acquired after a bidding war in 2006.

"Although we find very little to like about the Pliva acquisition, we believe that most of the integration risk has now passed," adds Cowen's recent research report. But Cowen also says Barr "is about to enter what could be an exceedingly strong new U.S. product cycle."

Cowen expects a revenue boost from Barr's generic version of the Bayer oral contraceptive Yasmin. Barr's drug could reach the market in June or July. Given the complexities of patent challenges and regulatory approval for generics, Cowen says Barr could be the only seller of generic Yasmin through 2010.

The firm also says Barr will benefit from being the first seller of a generic copy of Adderall XR, the attention deficit hyperactivity disorder drug from Shire ( SHPGY). The U.S. launch is expected in April 2009.

None of the analysts mentioned above own shares. Goldman Sachs has had a recent investment banking relationship with Barr. Merrill Lynch says it does, or seeks to do business, with companies mentioned in research reports.

Barr's purchase of Pliva was matched by Mylan's bigger acquisition of the generic-drug business of the German drug and chemical conglomerate Merck KGaA. Along with another deal giving Mylan a majority stake in India's Matrix, Mylan has created the world's third-largest generic-drugmaker and some indigestion for investors.

Mylan is now trying to sell Dey, a developer of drugs for respiratory ailments and allergies, which was part of the Merck deal. Mylan took a $385 million goodwill impairment charge for Dey, which contributed to a first-quarter operating loss of $371.5 million and a net loss of $443.9 million.

During the quarter, Mylan said the various Merck businesses, especially those outside the U.S., produced, on average, lower profit margins than Mylan's U.S. subsidiaries. Analysts say future risks include integrating the Merck businesses and producing greater value from the acquired products.

Mylan also cut its earnings projections not only for 2008 but also for 2009 and 2010. "The guidance for all three years is lower than what the investment community had expected," says a report by Credit Suisse, which has had a recent investment banking relationship.

"The bar has now been reset lower, but we believe it will take a few good quarters for investors to regain confidence in the name," the firm adds. Credit Suisse is keeping its outperform rating, and the firm is one of nine sell-siders with buy ratings, says Thomson Reuters. Four firms have hold recommendations.