Drug Stocks Rally: Consider These Profitable Stocks as Pharmaceutical Deals Rise

Mary Lynn Cesar, Kapitall: Will Actavis's announced $25 billion purchase of Forest Labs increase the appeal of drug stocks?

Leading generic drug company Actavis (ACT) agreed to buy branded drug maker Forest Laboratories (FRX) for $25 billion on Tuesday morning. The agreement states that Actavis will acquire Forest Labs for $89.48 per share in cash and stock. Following the announcement, MarketWatch reports that shares of Forest Labs and Actavis surged by 30% and 7.9%, respectively, in early morning trading.

[Read more from Kapitall: Will Offshore Tax Havens Face More Scrutiny in 2014?]

The Actavis-Forest Labs deal is the latest consolidation in an industry increasingly beseiged by bids and acquisitions. Last year Actavis rejected multi-billion dollar offers from fellow generic drug makers Mylan Inc. (MYL) and Valeant Pharmaceuticals (VRX), opting to purchase branded drug manufacturer Warner Chilcott for $5 billion instead. According to Bloomberg, roughly $110 billion in drug and biotechnology deals took place between February 2013 and February 2014.

More deals are expected as Valeant CEO Mike Pearson seeks to build his firm into one of the largest drug companies in the world with a market cap exceeding $150 billion by the end of 2016. Just this month Valeant acquired privately held PreCision Dermatology for $475 million. And Businessweek writes that Pearson told Goldman Sachs conference attendees in January that later this year Valeant plans a “significant” deal similar to its earlier $8.7 billion acquisition of Bausch & Lomb.

Investing Ideas

The recent activity in these drug stocks inspired us to look for other investment opportunities in this sector. To begin, we constructed a universe comprised of drug stocks belonging to the "drugs manufacturers – generic" and "drug manufacturers — other" industries. We selected those specific industries instead of using all drug-related segments because Actavis belongs to the former while Forest Labs is part of the latter.

We then screened for increasingly profitable stocks as indicated by rising gross profit margins year-over-year for the last three years. Gross margin is the percentage of profit a company makes for each dollar it generates in sales, after deducting production expenses. Examples of these expenses include operating costs, payroll, and taxes. The formula is:

Gross Margin = Gross Profit / Revenue

The higher the percentage, the greater the gross profits a company takes from its revenue. When a company has rising gross margins, it indicates that the firm is in control of its costs.

Next, we screened for stocks that are rallying above their 20-day, 50-day, and 200-day moving averages (MA). This indicates that these stocks have strong upward momentum.

We were left with four drug stocks on our list.

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