Pharmaceutical stocks have been rallying of late, buoyed by news of richly priced mergers, including Roche's $44 billion bid for Genentech (DNA) on July 21 and the $7 billion offer by generic drugmaker Teva Pharmaceutical Industries (TEVA), a few days earlier, for rival Barr Pharmaceuticals (BRL). But it's not just consolidation that's drawing investors to drug stocks. Even in the face of unprecedented challenges, ranging from patent expirations on billion-dollar products to an increasingly tough regulatory environment, investors keep piling in. On July 15, the market value of health-care stocks in the Standard & Poor's 500-stock index exceeded that of financial-services firms for the first time since 1992. The American Exchange Pharmaceutical Index is up 4.1% since July 1, while the S&P 500 has dropped 1.7%.
But amid this pharmaceutical frenzy, investors got a sobering reminder of just how risky it is to be investing in drugmakers. On July 21, Schering-Plough's (SGP) shares—which had rallied 35% in the prior three months—plunged 12% on news that its embattled cholesterol drug Vytorin performed poorly in a clinical trial. The news also pushed down shares of Merck (MRK), which co-markets Vytorin.
The share declines underscored the risks of flocking to pharmaceutical companies as safe havens in bear markets. Investors often favor drugmakers as an alternative to battered sectors because people generally don't stop taking their prescription drugs when their pocketbooks get squeezed. Most large pharmaceutical companies have healthy cash flows, and they pay generous dividends, even in the worst of economic slumps. What's more, investors can make out fabulously when they place bets on companies that are strong takeover targets: Roche offered a 9% premium over Genentech's previous closing price, while Teva offered to pay 43% more than where Barr's stock had been trading.
Unfounded Reputation for Stability?The drug industry's safe-haven status is coming into question, as even the most basic assumptions about its stability are proving untrue. In the second quarter, the number of prescriptions fell for the first time since the mid-1990s. Polls show that because of rising health-care costs, patients are more apt to skip doses or cut their pills than they were three years ago. And nearly one-quarter of patients report not filling a prescription because of expenses, says the Henry J. Kaiser Family Foundation.
Add in the long-term threats to the industry, and it starts to look as if cash or perhaps U.S. Treasuries might be a safer investment than drugs. Some of the biggest industry names are facing daunting patent expirations. Pfizer (PFE) will lose its $13 billion-a-year cholesterol blockbuster, Lipitor, to generic competition in 2011. Bristol-Myers Squibb's (BMY) powerhouse blood thinner Plavix, with $5 billion in sales, goes off patent that same year. Merck already lost patent protection for its $3 billion osteoporosis drug, Fosamax, earlier this year.
Drug companies are trying desperately to come up with substitutes for these big products, but even there, Big Pharma is struggling. Part of the problem is that the Food & Drug Administration has become increasingly picky and cautious. The federal regulator has been rejecting more drugs because of safety concerns or a lack of compelling evidence that they represent a true advance over what's already available. In April, Merck suffered two FDA rejections in three days, including one for a cholesterol drug that analysts had predicted would be a blockbuster.
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