New Directions in Healthcare Investment: Is The Age of Pharmaceutical Companies Over?

I actually wrote the below in an article for FT in 2005 but, after reading the news that Pfizer (PFE) finally pulled its next blockbuster drug torcetrapib out of clinical trials after many patients died due to unexpected side effects, I feel like I could have written it today:

Blockbuster success is a double-edged sword. In this litigious society, a discovery of side-effects brings an army of tort lawyers to the doorsteps of pharmaceutical companies.

The demographic trends of aging baby boomers will push demand for the pharmaceuticals into the stratosphere for a long time. However, investors should add another dimension to their analysis – product diversification. Companies that have a high concentration of sales in just a few blockbuster drugs should either be avoided or given a much smaller place in the portfolio. Also, investors should temper valuation premium expectations for the overall sector, as it is unlikely to return to its old levels.

Medical device/instrument companies are likely to take over leadership from pharmaceutical companies and inherit the premium valuation [Zimmer (ZMH) and Biomet (BMET) come to mind here]. They will reap the rewards from the baby boomers’ desire for longer and healthier lives. With few exceptions, medical device/instruments companies have a much more diversified product line.

Companies that provide services to the pharmaceutical industry are a good side-door to participate in the industry’s future prosperity without subjecting investors to all the risks. IMS Health (RX), a provider of market intelligence to the pharmaceutical industry, comes to mind as a good side position. It has all the qualities of a pharmaceutical company - strong competitive advantage, terrific return on capital, monopoly-like profit margins, great cash flows, very reasonable valuation and good consistent growth prospects ahead - without all the aforementioned risks. [I no longer own RX, but it maybe a good time revisit the stock.]

RX 1-yr chart

Disclosure: Author holds a position in ZMH