Pharma Is on Fire

I don't know if you've noticed, but pharmaceutical companies -- the big boys such as Pfizer (NYS: PFE) , Merck (NYS: MRK) , Eli Lilly (NYS: LLY) , and Sanofi (NYS: SNY) -- have been on fire over the last six months, trouncing the S&P 500.

PFE Total Return Price data by YCharts.

What happened to that patent cliff?
It happened; it's just that everyone saw it coming.

That's the nice thing about the industry: When sales fall because of generic pressure, there's usually years of advanced warning.

Investors can adjust their expectations and valuations in line with the expected declines. Assigning a P/E of 6 isn't all that weird if you know earnings are going to get cut substantially in the near future.

And lead-up allows companies to adjust their spending to the new reality of the situation. For instance, after losing Lipitor to generic competition, Pfizer cut its spending by 16% in the second quarter.

Thanks, Ben!
I suspect that part of the price appreciation has nothing to do with the fundamentals of the pharmaceuticals and much to do with the fact that Ben Bernanke and the Federal Reserve have kept interest rates so low. If investors can't get income from bonds, they're going to seek it in dividends offered by stable companies.

Source: S&P Capital IQ.

Dividend yields have come down a little as the prices have gone up, but investors that purchased six months ago are sitting on the same return on their initial investment that they were a few months ago. And they've got the added benefit that their initial investment is worth a little more.

Can it last?
Short answer: No! At least the growth can't continue in its present form.

Cutting costs is all well and good, but it can only last for so long. At some point, a company becomes as efficient as it can be.

And without increasing cash flow, dividends can't grow. Investors love their dividends, but yields can only go so low. For the price to rise further, dividends have to also increase so the yield stays constant.

The solution, of course, is to develop new drugs. Or acquire or license them from biotech companies. Or expand the use of the current drugs into new indications. It doesn't really matter how, as long as the drugs get approved and make enough to cover the cost of their development/acquisition.

More risky
The downside to relying on the pipeline for share-price growth is that the big pharmas become a lot less stable. Bristol-Myers Squibb (NYS: BMY) for instance, fell 8.3% in one day after it announced that it was halting development of hepatitis C drug BMS-986094 over safety concerns. Sure, that's not as risky as biotechs, where 50% or more drops are commonplace, but that's not the stability investors are generally looking for when they purchase big pharma.

The reliance on pipelines is only going to get worse as the drug companies get back to the basics and shed their non-core assets. Pfizer has sold off its nutrition business and is spinning out its animal-health business. Abbott Labs (NYS: ABT) is separating its drug business from its more diversified portfolio of medical devices and nutrition products.

I think large pharmas will always have a place in well-diversified portfolios, but investors might consider buying a basket of them or purchasing an ETF to gain a broader exposure and decrease the volatility that will likely increase under the new pharma model.

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The article Pharma Is on Fire originally appeared on Fool.com.

Fool contributor Brian Orelli has no positions in the stocks mentioned above. The Motley Fool owns shares of Abbott Laboratories. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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