The Pharmacist Is In

Since George Bush took office in 2001, the Standard & Poor's Pharmaceutical index is down 27.4%. The S&P 500 index is up 1.9%. If you count reinvested dividends, it's a decline of 17.4% for the pharmaceuticals compared to a gain of 12.5% for the S&P 500. That performance ranks 81st out of 98 S&P sectors.

I concede that I've been swimming against the tide by recommending the drug makers in recent years. My logic has been two-pronged. First, simple demographics: The aging of the baby boom population portends an all-but-certain surge in demand. Second, given the resources and incentives, science and human ingenuity will bring an end to the recent dearth of blockbuster drugs on the horizon. In my view, everything else, including which party controls Congress and on what terms Medicare pays for a prescription-drug benefit, is so much static.

While I can't say this logic has been widely embraced, to judge from the dismal stock prices, I haven't fared so bad. In the wake of Merck's (MRK) Vioxx debacle, I urged investors to abandon individual drug stocks and invest instead in broad health-care mutual funds and exchange-traded funds. I followed that advice, and concentrated my pharmaceutical holdings in the iShares Nasdaq Biotechnology Index (IBB) and the iShares Global Healthcare Sector (IXJ) ETFs, and in the Jennison Health Sciences (PHLAX) mutual fund.

It's been a relief not to worry every time I read about a new drug failing its clinical trials or another recall. Jennison Health Sciences is my largest holding, on the grounds that active management pays off in a highly specialized, information-intensive industry like health care, and so far that has been borne out. I chose the fund after doing research on this site, and its one-year and three-year returns have been 9.1% and 22.2%, respectively. The 22.2% three-year annualized return ranks the fund in the top 2% of its category. (My thanks and congratulations to fund managers David Chan and Michael Del Balso.) The ETFs have been less spectacular. For IXJ the one- and three-year returns are a respectable 8.98% and 8.65%; for IBB 3.23% and 4.49%, lower than a risk-free CD.

Nonetheless, I believe my underlying thesis has shown signs of coming to pass, even if it seems to be happening off the radar screen of most investors. The aging population and the prescription-drug benefit do seem to be fueling demand, and Merck, largely written off after Vioxx was pulled from pharmacy shelves two years ago, has at least five promising new drugs in its pipeline, including a painkiller substitute for Vioxx that doesn't carry the same cardiac risks. Pfizer (PFE) has been investing heavily in antiaging products, a promising line of research likely to be given new impetus by the much-heralded discovery of antiaging properties in red wine. The pharmaceutical stocks were finally showing signs of life until last week's elections, and the sector is still up 13% year to date.

I'm not going to wade into the merits or lack thereof of the Republican-sponsored prescription-drug benefit, whose passage led to an earlier selloff in pharmaceutical stocks. My view is that for the most part, anything that increases demand is good for the industry. Has socialized medicine in Europe hurt the big European drug makers? No. It has increased demand — and profits. The last time I checked, the French took more antidepressants by far than any other nation in the world. Are the French any more depressed than the rest of us? On second thought don't answer that. But consider who's paying for all those antidepressants. By and large, it's the government.

In any event, the notion that the new Democratic majority is filled with wide-eyed radicals seems absurd. There has certainly been some anti-big-business rhetoric emanating from a few of the new members, but most of the talk has been about compromise, finding common ground and getting something done. There's still a Republican president likely to veto anything too radical. And the Democrats are getting ready for 2008. This isn't the time for something divisive and controversial.

I'm comfortable with my overweight position in health care. I'd buy more on further weakness. And one of these days, I predict pharmaceutical companies will again emerge at or near the top of the sector rankings.