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An investor check-up on pharma stocks Add to ...

Pharmaceutical stocks are supposed to be classic defensive plays, providing stability in rocky markets and spinning out reliable dividends in good times and bad.

Yet drug stocks have given investors plenty of nasty side effects in recent years, which explains why some money managers have sworn off them even as others see compelling value in the sector.

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"They're just not predictable businesses, that's the issue," says Larry Sarbit, manager of the IA Clarington Sarbit U.S. Equity Fund. He sold his drug stocks in the 1990s and hasn't owned any since.

Pharma stocks are a lot like technology companies, which spend enormous sums on research and development with no guarantees that new products will pan out, he says. That uncertainty makes it impossible to predict earnings several years in the future, which is one of the criteria he uses when selecting stocks for his fund.

"It's almost like you're on a hamster wheel," he says. "Drug companies are constantly eating cash because they've got to keep reinventing themselves."

With several blockbuster drugs coming off patent - including the world's best-selling drug, Pfizer Lipitor, which loses its protection this year - the pressure to invent new medicines has never been greater. At the same time, however, drug development costs have risen, and increased regulatory scrutiny sparked by high-profile safety recalls including Merck Vioxx, which was withdrawn in 2004, have made it tougher to bring new drugs to market.

It's a dramatic reversal from a decade ago, when pharma stocks were trading at sky-high valuations as the industry churned out new pills for whatever seemed to be ailing the population.

"My view on this is that the pharmaceutical industry is a victim of its own success," says Paul Harris, partner and portfolio manager with Avenue Investment Management. "Ten or 15 years ago they came out with these massive blockbuster drugs like Viagra and cholesterol drugs, so everybody assumed that they were always going to have blockbuster drugs, but they don't. It was a once-in-a-generational thing that happened."

As drug pipelines dried up, drug companies were forced to merge or buy biotech firms as a source of new products. Health care reform in the United States added another layer of uncertainty to the sector, putting further pressure on the stocks.

Shares of Pfizer, for example, are down about 60 per cent from their level of 10 years ago. The company slashed its dividend in half when it bought Wyeth for $68-billion (U.S.) in 2009. Pfizer has since raised its quarterly payment twice, but the dividend is still well below where it was before the cut.

Another casualty is Merck, whose stock is down more than 50 per cent over the past decade and which hasn't raised its dividend since 2004. In a reminder of the perils of investing in this sector, Merck's shares plunged last week when the company halted a late-stage trial for the potential blood thinner vorapaxar and stopped giving it to stroke victims in another study.

Despite the risks, some investors say many pharma stocks are trading at attractive valuations compared to the lofty multiples of a decade ago.

"We like the fact that they're cheap. We like the fact that everybody hates them. We like that for the most part the big pharmas have nice yields," says Norman Levine, managing director of Portfolio Management Corp.

One of his favourites is Bristol-Myers , whose promising drug pipeline should help to compensate for the loss of revenue when its biggest drug, blood thinner Plavix, faces generic competition in 2012. The stock trades at an inexpensive multiple of 11.5 times estimated 2011 earnings and sports a 5.1-per-cent dividend yield.

In addition, he owns Teva , a generic drug maker, and Covidien , which makes medical devices and pharmaceuticals. He also has a position in Pfizer, but plans to sell the stock "because we don't like its potential growth profile … it's too hard for them to show any growth at their size."

For investors who want exposure to the sector but aren't comfortable buying pure pharma stocks, there are a couple of ways to go. One is to buy a diversified health care company such as J&J (J&J), whose pharmaceuticals business is complemented by its consumer products and medical devices divisions.

"We own J&J. I like it because it's not a pure pharmaceutical company," says Avenue Investment's Mr. Harris. "That diversifies us nicely because they're not dependent on these huge blockbuster drugs."

J&J yields 3.5 per cent and has raised its dividend for 48 consecutive years. He also likes - but doesn't own - Glaxo , which has a big presence in vaccines and yields 5.2 per cent. The vaccine market is attractive, he says, because it covers large populations, unlike niche drugs that target specific diseases.

Another option is to invest in a broad-based exchange-traded fund such as the iShares Dow Jones U.S. Healthcare ETF. It holds 127 companies, a majority of which are pharmaceutical and biotech firms. The dividend yield is 1.6 per cent.

"If you're a retail investor, [investing in an ETF]is probably the easiest way to do it if you don't want to make a decision about individual companies," Mr. Harris says.



Big yields, big questions



Pfizer Inc.



Yield: 4.4 per cent



Facing the loss of patent protection on its blockbuster cholesterol drug Lipitor, the world's biggest pharmaceutical company shelled out $68-billion (U.S.) last year for Wyeth. Pfizer also chopped its dividend in half.





Bristol-Myers Squibb Co.





Yield: 5.1 per cent



Bristol-Myers' best-selling drug, the blood thinner Plavix, is poised to lose market exclusivity in 2012. But the company has a solid pipeline that should help to offset the loss of sales, analysts say.





Eli Lilly & Co.





Yield: 5.6 per cent



Best known as the maker of Prozac and Cialis, Eli Lilly sports a juicy yield but hasn't raised its dividend since 2008. The company faces a series of patent expirations and its pipeline has been hit by setbacks.



Follow on Twitter: @johnheinzl

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