Bargains Abound in Big Pharma Stocks...
By Nilus Mattive | March 08, 2011 |

About a month ago I told you about some of my favorite sectors for income right now, and healthcare was one of them. Today I want to drill down a little further and talk about a specific industry within that group — the major pharmaceutical firms.

Right now, a lot of investors are asking themselves:

Are Drug Stocks a Prescription for Higher Income or a Recipe for Disaster?

I don’t want to leave you guessing as to my answer. I think that, despite the challenges, many big pharma stocks are great values right now … especially if you’re the kind of person who likes fat dividend payments.

But before I get into the positives, let’s first talk about the problems these companies face.

Patent expirations are clearly the biggest hurdle right now.

For at least a few years now, the world’s major pharmaceutical companies have been dreading an impending sea of blockbuster drugs losing their patent protection. And this is a major reason that the group has been struggling to gain investor favor.

Worse, 2011 is the year that many fears become reality. Pfizer is losing three patents worth annual sales of at least $13 billion. Lilly and Novartis will each say goodbye to single patents each worth $5 billion a year. And other companies are in similar boats.

Obviously, big pharma isn’t sitting around twiddling its thumbs: Researchers are working frantically to discover new compounds and get them through clinical trials.

But there have been setbacks there, too: All told, the Food and Drug Administration issue about 20 percent fewer approvals in 2010 than in 2009 or 2008.

Worse, some of the FDA’s latest rulings have been downright perplexing. Consider the case of Tarceva, which was being jointly developed by OSI Pharmaceuticals and Genentech. The FDA’s advisory panel voted 12-1 AGAINST the drug … yet the organization approved it anyway. Then, in a separate case, the FDA rejected a drug (Esbriet) even though the panel was in favor of approval.

These mixed messages aren’t just frustrating (and costly) to the companies involved. They create further uncertainty for anyone investing in the industry. No longer does a positive FDA panel equate to a forthcoming product on the market!

Speaking of regulators and lawmakers, there is also massive uncertainty surrounding broad-based government actions related to the health care sector.

In the U.S. we have President Obama’s reform measures — which threaten to crimp profits from prescription drug sales. Meanwhile, Europe’s fiscal woes are causing countries to revisit their own healthcare budgets.

The end result could be new limits on how much drug makers can charge for their products in these markets, as well as other legislative measures aimed at steering consumers toward cheaper alternatives. And it’s important to note that Europe alone accounts for roughly 30 percent of worldwide drug sales.

However, Big Pharma Will Solve these Problems, And at Current Prices, the Worst Is Priced In

Here’s a chart of the Dow Jones U.S. Pharmaceuticals Index …

As you can see, major drugmakers have bounced only somewhat since the market’s major low in March of 2009 … and they are still far off their former highs reached around the new millennium.

The problems I outlined above are already well known and help explain why big pharma stocks have missed out on most of the market’s big rally. Yet I would hardly call this industry down for the count.

Instead, I would argue that the skeptics have swung the pendulum too far … and that there are plenty of reasons to be positive on the group going forward, especially at current valuations.

Those big patent expirations? While troubling, many of them won’t really hit results until 2012, giving companies at least another year to work on new products.

Meanwhile, recent acquisitions — particularly in the area of biotechnology — should help these firms develop new blockbuster candidates even with a schizophrenic FDA. For example, Pfizer gobbled up Wyeth in October 2009 … and is now in the process of completing its acquisition of King Pharmaceuticals.

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Heck, even if no quick replacements come, big pharma still boasts plenty of “small” products that add up to many billions in annual revenues.

What’s more, a quick look at the industry’s dividend payout ratios shows very ample cash to cover future checks. Take a look …

Moving on to all that government interference: Certainly the winds are blowing less favorably for the industry right now. However, in the U.S. at least, the Republicans have made it very clear that they intend to undo Obama’s healthcare plan.

In addition, losses in Europe could easily be offset by newfound opportunities in emerging markets!

While global pharmaceutical sales are expanding about 5 percent a year, demand for drugs in emerging markets is rising at triple that rate. And in places like China, it’s growing even faster.

The reason for this burgeoning new overseas opportunity is fairly simple: Growing middle classes that are becoming more Westernized in nearly every way — from higher incomes to increasing incidences of diseases that already plague wealthier nations.

So put me in the camp that believes now is the time to scoop up some big pharma stocks … before mainstream investors come flocking back to the group, or the big challenges are solved.

I’m already recommending two of these companies for my own father’s income portfolio, and I suggest you consider the strongest names for yourself, too.

Of course, if you don’t like holding individual shares, you can also get a broad stake in these companies through a pharma-focused ETF such as the SPDR S&P Pharmaceuticals ETF (XPH).

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-- Nilus Mattive

Source: Money and Markets