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While Everything Else is Falling, These Stocks
Are Soaring...
By Rob Fannon, editor, Phase 1 Investor
July 19, 2008
I love getting phone calls from my colleague Steve Sjuggerud. But often, I never have anything positive to say...
In the last two years, Steve has called me three separate times to talk about big drug stocks like Pfizer and Merck. I've given him the same advice each time... Stay away. And I don't think I'm going to tell him any different anytime soon.
As Steve wrote in a recent DailyWealth, Pfizer – the bellwether Big Pharma stock – is cheaper than it's been in recorded history, trading for less than 10 times forward earnings. And yes, the big drugmakers are "hated" – 97% of the population has an unfavorable view of the industry. Even lawyers and politicians rank higher on trustworthiness scales.
But Big Pharma fails on Steve's third criteria for investment – an uptrend. The industry is facing just the opposite...
Pharmaceutical stocks are down 15% from their highs this year... and almost 20% from their 2007 peak. That's because the world's biggest drugmakers are racing off the side of a cliff – a patent cliff.
Patent protection is the moat in the drug industry. But unlike other competitive advantages, including brand name, the patent moat has a 20-year expiration date. Once a drug goes off patent, generic drugmakers flood the market with copycats. These copycats can destroy brand-name sales.
Last year, $16 billion worth of brand-name drugs went off patent. This figure will rise to more than $100 billion by 2011, as 70 of the 100 top-selling drugs in the business will lose patent. Pfizer stands to lose 50% of its $48 billion in annual sales to generic drugs within three years, when Lipitor, the world's top-selling drug, loses patent protection.
Drug development is a costly and risky business. It takes an average 10 years and $1 billion to bring a new drug to market. The failure rates are extraordinarily high. There's nothing Pfizer, Merck, or Bristol-Myers can do overnight to replace expiring patents... Or is there?
As Steve has mentioned, big drugmakers are replacing lost sales by cherry-picking new drugs from the biotech industry. Biotech drugs are harder to copy than traditional drugs, making them more expensive to produce and less prone to future competition from generics. So drugmakers are willing to pay up to get a few biotech drugs in the pipeline.
In April, for example, the biggest Japanese pharmaceutical company – Takeda Pharmaceuticals – paid close to $9 billion to acquire Millennium Pharmaceuticals. In other words, Takeda handed Millennium shareholders a 53% profit over the previous day's closing price. These deals will only get more frequent as Big Pharma gets more desperate. That's why I love biotech stocks for the long term...
The problem with this long-term thesis is that biotech stocks in general have been "dead in the water" for the past few years. The sector enjoyed a big run from 2003 to 2005. It's taken time to digest those gains... and money managers have been more focused on commodities since then.
But I think this "dead money" period may be ending...
In the past month, biotech was one of the few sectors to show positive returns. Oil stocks, financial stocks, and consumer-spending stocks have been killed. Many biotech stocks, on the other hand, are doing well. As Brian Hunt mentioned in yesterday's Market Notes, the S&P Biotech ETF just hit a new high for the year.
There's a good reason for this strength. A struggling economy won't hurt biotech and medical as much as, say, an automaker, retailer, or restaurant chain... And biotech is one of the few industries showing solid sales growth.
A big holding in the S&P Biotech ETF, Gilead Sciences, just reported a 22% increase in quarterly sales growth. A slew of big biotech players report earnings next week, and I expect more great numbers.
Several ETFs give you broad exposure to biotech. Just enter "biotech" in the search box on www.etfconnect.com for a full list of funds. (A warning on the HOLDRs Biotech ETF – I'd avoid it... It's ridiculously weighted toward just four high-profile companies.)
The really huge gains in biotech will be made with the best individual companies. Pick the right one and you could easily multiply your money by four or five times.
Whichever route you choose, I encourage you to pay attention to the biotech sector. It has a terrific long-term outlook and it's getting started on another run higher.
Good investing,
Rob
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