Five Reasons to
Look at Pharmaceutical Stocks
Pharmaceutical companies offer unique
opportunities for investors. As the Baby Boomers age, more people must
regularly buy high-margin prescription drugs. New biotechnologies move
more and better drug treatments through a faster FDA approval process.
And, managed care relies on medicines to save money on health care costs.
This industry demands an investor's attention.
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By Jeff Fischer (TMF
Jeff)
The pharmaceutical business is so
attractive that it's a wonder we don't hear its praises sung more often.
Airplanes should circle the planet dropping leaflets: "Forget about
investing in Coca-Cola (NYSE: KO).
Invest in leading pharmaceutical companies." The reasons for ebullience
are many.
Coca-Cola is often heralded as a repeat-purchase
business. True, it is, but only as long as people want to keep drinking
Coke. Pharmaceuticals are better than that. The chronic nature of many
diseases means that a majority of medications are anything
but a one-time sale. When a patient is placed on medication,
it's often a prescription taken for several years, even lifelong. Remember
"take your medicine"? Repeat business leads to reliable earnings at
pharmaceutical companies, because each new patient represents an annuity
revenue stream.
This has always been true. Combine this fact with
current demographics and industry trends, and there is strong reason to
believe that pharmaceuticals are entering their strongest period ever --
and will only shine brighter in the near, intermediate, and distant
future. There are primarily five factors that make leaders in this
industry among the best long-term investments of any sector.
1) A "must-repeat" purchase, high-margin
business. Pharmaceutical companies sell products necessary for
health -- not for some discretionary need. These products usually
represent a must-repeat purchase, no matter the economic
situation.
Alongside this are the high margins at which companies
are able to sell drugs. Once established, leading pharmaceutical companies
often achieve operating margins above 30%, which is twice that of the
average S&P 500 company. This is possible despite high research and
development expenditures. Plus, patent protection usually guarantees high
margins on new drugs for at least a decade. (Note: Yes, patents granted
today provide a 20-year monopoly to the drug maker, but the patent usually
relates back to its application date, earlier in the drug development
process, before the drug hits the market.)
2) Favorable
world demographics. People 65 years and older use three to four
times the prescription drugs used by people in their 30s, and the world
population is aging. In the United States, the group of people 65 or older
will expand 17% by 2010, increasing the U.S. market for pharmaceuticals
well beyond the current $105 billion level. Outside the U.S., most of the
industrialized world is also moving toward the later years of life,
meaning the $188 billion worldwide pharmaceutical market will grow even
more quickly than usual. U.S. firms currently hold 30% of the world's
market share for pharmaceuticals, and that market share is rising. Plus,
not only is the world's population aging, it's also growing.
3) Improved science brings more cures. This positive
factor represents a one-two punch for pharmaceutical companies. Concurrent
with the aging population and its logical increase in health ailments, the
pool of medications available for sale is ever-expanding. Science has
advanced as much in the past 15 years as it did in the previous 40, with
biotechnology and combinatorial chemistry (the science of finding the
right compounds to work on targets -- getting the right drug to make the
required effect on the virus, or bacterium, etc.).
In short order,
combined medications for AIDS that greatly prolong life have been
developed, along with blockbuster drugs like Prozac, Zoloft, and Pfizer's
Viagra, to name three.
Science continues to advance. Past success
(and even failure!) almost always extrapolates into more knowledge and
more progress toward new medicines. Perhaps more than any other industry,
pharmaceutical companies are able to grow their businesses in more
directions without fear of diluting their mission, moving beyond their
core competency, or confusing customers. Addressing health concerns is
what these companies do. They can't possibly oversupply the market with
too many new products -- there are always more ailments that need curing
or treatment, and better ways to cure or treat ailments are always
welcome, as well.
In fact, ironically, as healthcare improves and
the average human lifespan increases, people need more and more drugs. For
example, people are living longer due to blood pressure medication. These
elderly people need other medications, perhaps for arthritis, Parkinson's
disease, Alzheimer's, and so forth.
4) A More Efficient
FDA Congress and the Food and Drug Administration (FDA) have
agreed that terminally ill patients have a right to use experimental drugs
in the hope that their lives can be saved or extended. These experiments
allow for better research and a faster "time to market" for new medicines.
Just as importantly, in the past two years the FDA has greatly reduced the
time it takes for a new drug to receive approval.
After years of
testing and refinement, the drug manufacturer submits its request for
approval to the FDA. Between 1987 and 1993, a typical new drug application
required 26 to 32 months, on average, for FDA approval. In 1998, it
required an average of only 11.7 months. Though it inched back up to 12.6
in 1999, the process is still much faster than before.
Plus, drugs
that are vitally important can be granted fast-track status and be
approved in as little as six to nine months. The more efficient approval
process brings drugs to the market quicker and allows for earlier and
larger profits. It allows for rejection sooner, too -- and that isn't a
bad thing. The earlier a company knows the FDA has rejected its drug, the
quicker it can develop a solution.
Not only this, but a quicker
approval process effectively means longer patent protection. When a
pharmaceutical company receives a patent for a drug, the legal right to
exclude others from making the drug lasts for 20 years (formerly 17 years)
after the patent application was submitted. The effective patent
protection period for a successful drug is usually only about 10 years,
after factoring in the time required to develop, test, and finally bring
the drug to market. The streamlined FDA approval process has chopped two
whole years from a drug's conception-to-market regimen, lengthening the
effective patent life by the same amount.
5) Managed
Care Providers Rely on Pharmaceuticals for Cost Savings. An
investor frequently hears that managed care providers are becoming
increasingly stringent regarding costs, and leading pharmaceutical
companies might suffer. In fact, an opposite argument can be made in favor
of pharmaceutical companies. The right pharmaceuticals and even a
combination of expensive drugs, if effective, can save organizations money
if they keep a patient out of the hospital.
While drugs can be
expensive, they still compare favorably to the cost of hospital stays. As
patent protection effectively lengthens for new drugs, even managed care
providers are forced to provide the best -- and most expensive -- drugs to
patients. This, in turn, supports leading pharmaceutical companies. This
won't likely change as long as drugs continue to save money, in the end,
by keeping people healthier and out of hospitals.
There you have
five good reasons to add pharmaceutical stocks to your portfolio. You can
use Foolish resources on the Pharmaceuticals sector
page to help you learn more and make your selections.
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