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Looking at the pharmaceutical industry as a whole, it's tough to find any drawbacks to investing in this sector. Consider:

  • The aging population and increasing instances of conditions like obesity will continue to create growing demand for pharmaceuticals. According to data from the IMS Institute for Healthcare Informatics, global drug spending will rise from $956 billion in 2011 to $1.2 trillion by 2016.
  • Drugmakers, such as Pfizer (NYSE:PFE) and Merck (NYSE:MRK), are poised to release blockbuster new medicines for cancer, diabetes, heart disease, multiple sclerosis and hepatitis.
  • While health care reform legislation will negatively affect overall profitability, it will also greatly benefit the industry by providing health insurance coverage to about 30 million uninsured Americans, which they can use to buy prescription drugs.
  • Pharmaceutical companies enjoy profit margins between 21% and 31%.
  • Drug companies consistently pay out strong dividends, with yields ranging from 1.7% to 4%.
  • The Food and Drug Administration approved 39 new drugs in 2012, which will soon come on the market.

Strong industry performance

The pharmaceutical industry has delivered strong stock-price performance over the last several years. Since 2010, these firms have outperformed the broader market; Pfizer has nearly doubled since its 2010 low, while Merck is up about 30%. Indeed, pharmaceutical indices and exchange-traded funds are pulling in double-digit year-to-date returns and some are generating well over 100% returns over the last five years.

Drug firms are doing an adequate job of cutting costs while also introducing popular new drugs. What's more, growth efforts are now focused on emerging markets. China in particular is set to become one of the most important growth drivers for Big Pharma over the next decade. Drug spending there has grown at a compound rate of 22% per year over the past six years.

The transition of the pharmaceutical industry from its traditional business model is ongoing. Companies are relying less on hitting a home run with a single blockbuster drug and opting instead for hitting singles by keeping the pipeline filled with drugs at various stages of development.

Drug companies have to be more strategic nowadays. Companies have to time the introduction of new compounds often to coincide with their previous drugs becoming open for generic competition. Once popular drugs have generic counterparts, sales plummet.

This pipeline management can take various forms. Large companies active on several therapeutic areas, like Pfizer and Merck, try to fill the pipeline with as many drug possibilities as possible. Call it the strength in numbers strategy. By contrast, specialized companies, like Novo Nordisk (NYSE:NVO) and Crucell (NASDAQ:CRXL), concentrate efforts on both fewer therapeutic fields and programs which might leave more room to focus on quality and to an early selection of a winner.

Diversification has presented itself as a solution for many companies that have started to look for alternatives to the blockbuster philosophy.

ETFs vs. Individual Company Stocks

Speaking of diversification, while the industry as a whole looks appealing, it's tough in the drug industry to forecast winners and losers. All it takes is for one promising drug to fail a trial, get turned down by the FDA for approval or suffer bad PR from a rash of side effects to negatively impact the bottom line of an entire company. Therefore, it's less risky to go with an exchange traded fund (ETF) for the pharmaceutical industry.

ETFs offer a convenient way to invest in sectors or niches that interest you. If you'd like to add some pharmaceutical stocks, instead of trying to figure out which companies will perform best, an ETF allows you to invest in lots of them simultaneously.

Below are a few examples:

Market Vectors Pharmaceutical ETF (PPH)

This ETF holds 25 of the largest publicly traded pharmaceutical companies. About 20% of those holdings are in the stocks of Johnson & Johnson and Pfizer. This fund has a 60-40 split between U.S. companies and international stocks.

PPH is current trading around $44 a share, with a 52-week range between $34.88 and $44.08. Its current price-to-earnings ratio is just under 16.

The fund has a year-to-date return of 10.77%, a one-year return of 19.87%, a three-year return of 38.23% and a five-year return of 32.14%. PPH has an expense ratio of 0.35%, and an annual dividend of $1.35 a share, which yields 3.06%.

Dynamic Pharmaceutical Holdings (PJP)

This ETF has 31 stocks in its portfolio, with its top holding, Bristol-Myers Squibb, (NYSE:BMY) accounting for only 5.13% of its holdings. This fund carries only U.S.-based company stocks.

PJP is trading around $38 a share. In the past 52 weeks, it has been valued between $29.63 and $39.01.

The fund has a year-to-date return of 11.94%, a one-year return of 26.27%, a three-year return of 99.52% and a whopping five-year return of 145.67%. It has an expense ratio of 0.60%, and an annual dividend of $0.55, which currently yields 1.42%.

Dow Jones U.S. Pharmaceutical Index Fund (IHE)

This ETF holds 36 pharmaceutical stocks. Like PPH, it has allocated 20% of its resources to Pfizer and Johnson & Johnson (NYSE:JNJ). All but 2.21% of its holdings are based in the United States.

As of March 15, IHE was trading only a few cents shy of its 52-week high of $95.73. Its low point in the last year was $77.92.

The fund has a year-to-date return of 12.09%, a one-year return of 19.14%, a three-year return of 68.98% and a five-year return of 118.06%. It has an expense ratio of 0.48%, and an annual dividend of $1.67, which currently yields 1.75%.

SPDR S&P Pharmaceuticals ETF (XPH)

This is a diversified pharmaceutical fund. It holds 31 drug company stocks, all in the U.S. Its top 10 holdings all account for between 4% and 5% of its overall holdings. More than 60% of its holdings are small to medium cap stocks.

XPH trades at just over $62 a share, cents away from its 52-week high.

The fund has a year-to-date return of 11.91%, a one-year return of 14.13%, a three-year return of 55.64% and a five-year return of 125.81%. It carries a 0.35% expense ratio, and pays out a $1.06 annual dividend currently yielding 1.70%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Catalyst Investments is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. This information is not investment advice or a recommendation or solicitation to buy or sell any securities. Catalyst Investments does not purport to tell or suggest which investment securities readers should buy or sell. Readers should conduct their own research and due diligence and obtain professional advice before making investment decision. Catalyst Investments or anyone associated with Catalyst Investments will not be liable for any loss or damage caused by information obtained in our materials. Readers are solely responsible for their own investment decisions. Investing involves risk, including the loss of principal.

Business relationship disclosure: This article was written by an analyst at Catalyst Investments.

Source: The Best Pharmaceutical Investments