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The Pharmaceutical Sector Looks Attractive

- By Ben Strubel

The health care sector has lagged the broader market over the current year, returning -0.39% year to date (as of this writing) before dividends, as measured by its most popular ETF, the Health Care PSDR ETF, compared to a 5.75% price return for the S&P 500. In fact, the underperformance of the health care sector really goes back to about the middle of last year (2015).

In order for an entire sector to underperform for a year and a half you probably need a pretty steady string of bad news. That is indeed what the health care sector has had. Over the past 18 months, we've had the following happen:

  • Multiple comments about drug prices being too high by presidential favorite Hillary Clinton
  • Scandals at both large and small pharmaceutical companies

    • Valeant Pharmaceuticals (VRX) and the scandals involving their use of specialty pharmacies and their accounting and pricing practices
    • Mylan (MYL) and the price increases for their EpiPen product
    • Turing Pharmaceutical raising prices on a drug by 5000% and the abhorrent behavior of its former CEO, Martin Shkreli

  • Negative press on the practices of pharmacy benefit managers
  • Inability of major health insurers to profit as much as expected from the Affordable Care Act (ACA) marketplaces

Indeed, there are very good reasons to avoid some areas of the health care sector. Development stage pharmaceutical companies are risky and as quickly as you can make 200% on a stock, you can lose everything as well. Pharmacy benefit managers such as Express Scripts (ESRX) are facing increasing scrutiny of their pricing practices and run the risk of health care providers in-sourcing services previously provided by PBMs. Health insurance providers may be hit or miss depending on changes to the ACA, and given the failure of certain areas of the ACA, some change is likely.

In one area, the market seems to have thrown the baby out with the bathwater, so to speak. Large, diversified pharmaceutical companies that research, develop and market new drugs have.

High drug prices are supported in the U.S. by four primary mechanisms. These are by no means the only things contributing to high drug prices, but they are the main ones. First, by law, the country's largest health care provider, Medicare, is prohibited from negotiating pricing for prescription drugs. Second, the amalgamation of remaining health care providers outside of the Veteran's Administration do not have the necessary scale by themselves to negotiate substantial price reductions. Third, the complex health care system in the U.S. does not make drug pricing fully transparent. Patients, health insurers, pharmacies, pharmacy benefit managers, drug wholesalers and pharmaceutical companies all only see a small part of the prescription drug value chain and the full cost of drugs can remain hidden as each person or organization can only see what is happening close to them. Fourth, patent protections provide companies with government granted monopolies. Reasons one through three are unique to the U.S., the only developed country without a single-payer health care system or some form of universal care, which means that the U.S. market remains an outside contributor to the profits of pharmaceutical companies.

That means that as long as no fundamental changes take place in the U.S. health care system, the ability of major pharmaceutical companies to profit from developing new compounds should not be impeded.

Major pharmaceutical companies are cheap

The chart below shows just how cheap many pharmaceutical companies have gotten.

The average forward price-earnings (P/E) ratio is less than 14.5, which is well below the current forward P/E of 18.4 of the U.S. stock market. The average dividend yield of over 3% is also about a full percentage higher than the S&P 500's yield.

Investors looking for stable dividend paying stocks would be well served by investigating the large cap pharmaceutical sector. Traditional "safe" consumer staples stocks trade at sky-high valuations as we've written about. For investors looking for income, the long-term returns of buying into a sector at below market and below long-term historical average valuations are likely to be rewarding.

We would recommend buying a basket of several companies to maintain a diversified portfolio. The recent events with Bristol-Myers Squibb (BMY) offer a good illustration why. Bristol-Myers' Opdivo drug was widely considered by experts to be a future blockbuster, but the results from several recent clinical trials have cast doubt on that. Bristol-Myers' stock has fallen 35% from its highs as a result. No matter how smart you are or how many doctorate degrees you have, there is always an element of uncertainty when it comes to pharmaceutical development and that uncertainty can be magnified when a large portion of a company's valuation depends on expectations for future success from one compound. Diversification is a must, whether it's by investing solely in well diversified pharmaceutical companies or diversifying at the portfolio level by buying a basket of stocks.

Disclosure: Long Johnson & Johnson (JNJ), Novartis (NVS), Roche Holding (RHHBY) and Merck (MRK).

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This article first appeared on GuruFocus.