Is This Dog of the Dow a Fiscal Cliff Cure?

It is nearly impossible to consider the stock market lately without some mention of the fiscal cliff. The health care sector in general and shares of Merck specifically are no exception; the stock is off 6.7% in the last two weeks as of Friday's close. Fellow Fool Matt Thalman explains: "The possible reduction to Medicare outlays has hurt not only the health-insurance companies, but also the drug manufacturers, as some believe the government will want to negotiate cheaper drug prices as a way to reduce the cost of government-run health programs." But with a dividend yield of 4.2%, Merck is one of the fabled Dogs of the Dow.

During a period in which investors are looking anywhere they can for yield, high-dividend stocks have maintained their popularity for several years. The Dogs of the Dow "is a stock picking strategy devoted to selecting the highest dividend paying Dow stocks." The premise of the strategy is that the quality companies that are included in the Dow Jones Industrial Average do not adjust their dividends based on market conditions, but the market adjusts their respective stock prices. Based on this, you can conclude that companies that have the highest dividend yields are "out of favor" within the index -- the Dow's underperformers end up having the highest dividend yields based on depressed stock prices.

If you include in your portfolio those stocks that have been out of favor in a given year, you expect those stocks to "recover" in the subsequent year. A backtest of the strategy reveals  that from "1957 to 2003, the Dogs outperformed the Dow by about 3%, averaging a return rate of 14.3% annually whereas the Dows averaged 11%." Without completely endorsing the strategy, it is often a great place to find good ideas for the year ahead -- and Merck, a buy at current levels, is one such idea of which to take note.

The fiscal cliff
For anyone late to the party, the fiscal cliff is the name given to the tax hikes and spending reductions that are scheduled to begin in January unless Congress acts quickly -- several tax relief measures will expire and sequestration initiatives will go into effect. Some of the tax changes include the end of the so-called Bush tax cuts, the end of extended unemployment benefits, and the end the payroll tax holiday. Sequestration refers to a series of previously-agreed-upon fiscal cuts as a part of a bi-partisan mandate.

The purpose of the initiative was to coerce the two parties to find resolution on some necessary spending reductions. Sequestration was to be the penalty for not reaching an agreement; to nobody's actual surprise, no agreement was reached.

Merck's woes create a buying opportunity
recently reported that the European Medicines Agency is reviewing Merck's latest cholesterol treatment Tredaptive because a recent study yielded disappointing results. According to the story: "In the study of 25,673 patients, Tredaptive failed to cut heart attacks, strokes, the need for artery-clearing procedures or death from cardiovascular disease more than cholesterol- lowering statin drugs."

While the drug resulted in sales of less than $20 million for Merck in 2012, some estimates had targeted sales of $300 million by 2016. Merck said it no longer planned to seek U.S. marketing approval for the drug and recommended that doctors stop proscribing the drug to new patients; existing patients may stay on the treatment protocol.

The company is still recovering to some extent from this year's patent cliff that cost Merck protection on its blockbuster asthma drug, Singulair; it accounted for 11% of the company's 2011 sales. The 2012 patent cliff was so named because in addition to Merck, Pfizer lost protection on Lipitor, and Bristol-Myers lost protection for Plavix.

While Merck is experienced in managing a comprehensive pipeline, the loss of such a critical revenue source is not trivial. Despite the loss, the company continues to boast an impressive pipeline, including 15 drugs in phase 3 trials.

Restructuring and global reach
According to Marshall Hargrave at Insider Monkey, much of what has pushed Merck into its role among the Dogs has been attributable to merger pressures. As cost savings are realized, the company will be positioned to perform. Hargrave also points out that Merck has dedicated significant resources to establishing a solid presence in China and other emerging markets.

Against the backdrop of the fiscal cliff, establishing this type of reach could help set the company up with a competitive advantage over Pfizer and Bristol-Myers. China is of particular importance because of the continued urbanization going on there; both the pediatric and adult vaccine markets are wide open and a target for Merck.

Ultimately, Merck is strongly positioned heading into 2013 and is a buy at current levels.

Before taking my advice, be sure to do your own research. To find out if Merck has the stamina to keep its Bunsen burners alight, grab your copy of our brand new premium research report today. Our senior biotech analyst Brian Orelli, Ph.D., walks you through both the opportunities and threats facing Merck, and the report comes with a full 12 months of updates. Claim your copy now by clicking here.

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Fool contributor Doug Ehrman has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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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