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Five pharma stocks to buy as patents expire Add to ...

Jamie Dlugosch is editor of Penny Stock Winners, is also a contributing editor of InvestorPlace.com and founder and editor of The Rational Investor.

Earlier this week it was reported that drug prices were set to fall as several top-selling drugs, including Lipitor and Plavix, came off patent protection. The quick reaction to such news is to steer clear of pharmaceutical stocks. After all, if lower prices result in less revenue and smaller profits, that must mean that pharmaceutical stocks will be worth less. Right?

The trouble with that simple reaction is that the market is already aware of the situation. The headline may be sensational, and it might worry those who own pharmaceutical stocks, but it's old news and likely to be already priced into these stocks. At a minimum, Wall Street analysts have factored the effect of patent expiration into future estimates of earnings.

You don't get a job on Wall Street without understanding such things well in advance of the event. Since the market prices stocks based on a discounted value of future profits, the Wall Street estimate is an important piece of the puzzle and ultimately quite reliable.

A nice thing about pharmaceuticals is that revenue projections based on patent protection are easy to forecast. Research and development spending is not so easy to predict – and the unknown of new drugs coming to market is what creates opportunity for investors. At the moment, there has been a dearth of new drugs, giving pharma investors pause before committing new capital.

Patient investors should be able to take advantage of buying opportunities in pharma stocks while everyone else sells or waits on the sidelines. Here are five names to consider.

Merck

Merck is the poster boy for what is wrong with the buy-and-hold investing strategy. If you'd owned the stock for the last 15 years, you wouldn't have much to show for it. In 1996, shares traded for about the same $35 (U.S.) price that investors can buy the stock at today. Buying in the mid-1990s only made sense to the extent that profits were taken when shares approached $100 in the early part of the new millennium.

For those willing to buy and trade, Merck is a perfectly legitimate speculation, and current prices make for an attractive entry point on the stock. The company is set to lose its patent on oral asthma and allergy drug Singulair, which generated $5-billion in global sales in 2010. The loss is a negative for certain, but Merck has previously endured the loss of other drugs, including Vioxx and Zocor.

Merck has vast resources and a deep pipeline of potential new drugs. In addition, the stock pays a dividend of 4.2 per cent. With shares trading for less than 10 times estimated earnings, Merck is a reasonable speculation. Just remember to sell down the road if shares are much higher.

Merck was featured recently in 5 Technical Setups to Buy for August Breakouts and is one of David Tepper's Top 5 Dow Stocks.

Pfizer

Pfizer another top Dow holding at Appaloosa Management, is the proud owner of best-selling drug Lipitor. The good news is that the decade-plus run of Lipitor kept the coffers at Pfizer full. The bad news is that the run is about to end, and the impact of that loss will likely be deeply felt in the short term. The question for investors is what the company has done to redeploy that cash in the search for the next Lipitor.

In 2011, investors have been bidding up shares, apparently speculating that Pfizer can absorb the loss as new drugs come to market. Shares have gained 12 per cent so far this year. Add in the 4-per-cent dividend and that is one heck of a return. Still, Pfizer at around $19.50 per share is well off its record high of nearly $50 per share a decade ago.

Wall Street has Pfizer generating a fractionally higher profit in 2012 than in 2011. Clearly there will be an effect in losing Lipitor, but the consensus is that the loss will not be disastrous. You can buy shares for less than nine times expected earnings. Investors today are essentially getting future new drug profits at a significant discount.

Pfizer, one of the top-yielding drug stocks, shows up on a recent list of Eight Top-Rated Stocks to Buy.

Bristol-Myers Squibb

The second-best-selling drug on the market is Plavix, owned by Bristol-Myers Squibb It comes off patent in 2012. The blood thinner most prescribed for heart attacks and strokes generated $9.4 billion in sales in 2010. Bristol-Myers is also set to lose the patent on high-blood-pressure drug Avapro in 2012. In addition, a deal to market Abilify also expires in 2012.

The impact of these very big developments for the company is a stock that has gained 9% so far in 2011. While Wall Street analysts have the company making less money in 2012 as a result of the losses from those key products, shares still trade for only 13 times current-year estimates. That premium valuation reflects the value of Bristol-Myers' pipeline of new drugs coming to market in key areas such as cancer.

That pipeline grew recently with the purchase of privately held Amira Pharmaceutical, which has a number of drugs in various stages of approval, including treatments for asthma that it secured by a marketing deal with GlaxoSmithKline Milestone payments from that deal may ultimately pay for the acquisition, giving Bristol a freebie with respect to other products.

It's a risky bet, for sure, but one that seems worth it.

Bristol-Myers, one of the top holdings of Bruce Berkowitz's Fairholme Capital Management and Steven Cohen's SAC Capital, is also one of the highest-yielding drug stocks.

Johnson & Johnson

Johnson & Johnson is more diversified than the other stocks on my list and should be even more able to withstand a loss of patent exclusivity. This year, J&J will lose the patents on antibiotic drug Levaquin and ADHD treatment Concerta. Those expirations come on the heels of J&J's losing the patent on antipsychotic drug Rispersdal in 2008 and seizure drug Topamax in 2009. The 2011 expirations generated a combined $2.7 billion in global sales in 2010.

J&J has seen its shares gain slightly in 2011. The stock is up a modest 5% in 2011. Because the company is diversified, it is hard to know the true impact of these drugs' coming off the market. From an operating performance perspective, the company is doing well relative to Wall Street expectations, having met or beaten estimates in each of the last four quarters. In the most recent quarter ended June 30, J&J generated a profit of $1.28 per share, 4 cents higher than the average estimate.

From a valuation standpoint, J&J is in line with other pharmaceutical companies, with shares trading for 13 times current-year estimated earnings. Wall Street expects J&J to grow profits by more than 6% from the current year to 2012, which is better than expectations of growth at other pharma companies.

J&J also pays a hefty dividend of 3.4%. I would expect the company to absorb these patent losses while it continues its search for replacements.

Johnson & Johnson, on the list of 2011's Dividend Aristocrats, is one of Warren Buffett's top 10 dividend stocks.

Eli Lilly

Eli Lilly is set to lose the patent on antipsychotic drug Zyprexa, which actually might be a good thing. Although Zyprexa has consistently delivered several billions in annual sales, the drug and the sale thereof have been controversial. In 2009, Eli Lilly settled litigation over Zyprexa to the tune of more than $1 billion, on the heels of previous settlements in the hundreds of millions due to claims that the drug was linked to increased blood sugar levels and diabetes.

Net-net, the drug was cash positive for the company, but the history is helpful in understanding the potential loss coming from increased competition. Shares of Lilly have gained 9% in 2011. In addition, the company pays a dividend of 5%. The total return would suggest that investors are not concerned about the loss of patents.

Wall Street is figuring a reduction in profit in the coming year. The average estimate for 2011 profits at Lilly is $4.29 per share. That number slips by more than 10% to $3.72 in 2012. At current prices, Lilly trades for 9 times current-year estimates. There would appear to be no surprises here, yet Lilly shares are performing quite well this year. Like any pharma play, investors are betting on the future. To do so at less than 10 times estimated earnings is a bargain.

Lilly, another of the top-yielding drug stocks, is one of the top holdings of Primecap Management.

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