Pharma Firms Set to Regain Their Health

Related Quotes

Symbol	Price	Change
ABT	48.98	-0.24
BMY	25.08	-0.04
MRK	35.06	+0.32
TEVA	47.17	-1.27

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With all the political talk about health care reform, not much has been said about one part of the health care industry that has experienced considerable indigestion. I'm talking about the pharmaceutical industry.

A lack of blockbuster new drugs, at a time when existing high-performing drugs will soon lose their patent protection, contributes to the industry's malaise. The Amex Pharmaceutical Index went up in 2009 by 13%, way below the S&P 500's gain of 23%. Year to date, the Pharmaceutical Index is down about 1%, vs. a gain of better than 2% in the S&P 500.

I have reason to believe things will improve for pharmaceuticals this year. They have been out of favor for so long, I believe the market will start to come back to them. Merger-and-acquisition activity in the industry is reasonably strong and probably will remain so, and that should draw in investors. And a number of the guru strategies I use to pick stocks -- these are computerized analyses based on the strategies of some of Wall Street's greatest investors -- are showing decided interest in pharma. Now is the time to start seriously looking at these sickly companies that are poised to start feeling better.

One such company is Abbott Laboratories. A huge company (ranked 80 on the Fortune 500), it derives about 60% of revenue from pharmaceuticals, while the remainder comes from nutritional products, diagnostic tests, medical devices and the like. The strategy I use that's based on the writings of James P. O'Shaughnessy likes Abbott because of its large market cap ($84 billion), positive cash flow per share, large number of shares outstanding (1.6 billion), large revenue base ($31 billion) and dividend yield (3.24%).

Also, the strategy I base on Peter Lynch's approach to investing gives Abbott very high marks. This strategy looks at the price-to-earnings ratio relative to growth (called the P/E/G ratio) as a way to measure how much the investor is paying for growth. This should be no more than 1.0 (where you pay $1 for every 1% of annual growth). Abbott's P/E is 14.7, and its growth rate is 25.2% (based on the average of the three-, four- and five-year EPS growth rates). This produces a very nice P/E/G of 0.58. Also in Abbott's favor: Inventories are well managed, and debt is not too high.

Another big pharmaceutical company worth a look is Bristol-Myers Squibb. The company was once in a variety of health-care-related markets, such as orthopedics and medical imaging, but it has divested itself of almost all of these businesses and is now nearly exclusively a developer and marketer of branded pharmaceuticals. Bristol-Myers' yield-adjusted P/E/G is a perfectly acceptable 0.75. Inventories are declining relative to sales, which is good, while debt is a bit less than half of equity, which is acceptable. This is a solid, well-performing major pharmaceutical firm, and one worth considering at this time.

Teva Pharmaceutical Industries is in a somewhat different market from Abbott and Bristol-Myers. This Israeli company is the world's largest generic drug company. When the drugs of companies such as Abbott and Bristol-Myers come off patent, Teva may swoop in and introduce a generic version and start taking market share. Because of its size and vertical integration (including making many of its own active ingredients), the company enjoys competitive advantages. Plus, as measured by the Lynch strategy, the stock is well priced. Its P/E/G is 0.92, inventory as a percentage of sales fell last year when compared with the previous year (showing good inventory control), and debt is only 29% of equity.

I will mention one more pharmaceutical that earns a high grade: Merck. Late last year, the company closed on a major acquisition, Schering-Plough, which strengthened Merck's product pipeline. The O'Shaughnessy strategy likes Merck for a variety of reasons, including the company's high market cap ($117 billion), positive cash flow per share, large number of shares outstanding (2.8 billion) and hefty sales ($27 billion). And among all the stocks which have passed these tests, Merck is a standout because of its 4.05% dividend yield.

These four companies have the support of the guru strategies. We don't know what will come of the Obama administration's efforts to overhaul health care, but these companies look as though they will weather the storm and continue to sail straight and true no matter what Washington decides. Since the pharmaceutical industry is somewhat out of favor, this could be a good time to get in.