IHE: Large-Cap Pharma Continues to Blow Away the S&P 500

While pharmaceutical stocks regained some of their momentum on high trading volume in March, iShares Dow Jones U.S. Pharmaceuticals Index Fund (IHE) investors should look to the fund’s underlying investment before purchasing shares. IHE’s top large-cap holdings are currently subject to a barrage of mergers and acquisitions that could significantly impact the sector. Despite the recent knockdown in pharmaceutical prices, IHE beat the S&P 500 by more than 23% for a one-year period ending April 3, helping the fund gain 19 spots on our Sector Momentum Tracker ETF rankings from April 1, 2008, to March 31, 2009.

IHE tracks the performance of U.S. pharmaceutical companies, including those that produce vaccines and prescription and over-the-counter drugs, but not vitamins. IHE’s top holdings are dominated by large-cap industry leaders, and the market cap of all 35 holdings averaged more than $44 billion. Despite the high trading volume of many of its components, IHE itself has a three-month average daily trading volume of approximately 50,000 shares. While its liquidity could trip up some short-term investors, IHE’s portfolio balance could prove inspiring to others: a reasonable 8.10% of the portfolio is dedicated to top component Johnson & Johnson (JNJ).

With a nearly 3.5% dividend yield, JNJ has been attracting cautious investors in recent months. JNJ’s history of dividend hikes is also reassuring: the company has upped its dividend in April for the past five years and has raised its dividend for 46 consecutive years. Analysts are concerned, however, that JNJ’s pharmaceutical business will be pressured by an influx of generics in the short term. A potential upcoming merger between Merck (MRK) and Schering-Plough (SGP) has analysts looking to JNJ for a response, the result of which could prove volatile for IHE’s underlying basket.

A recent merger announcement stated that MRK would pay $41.1 billion for SGP in a convoluted reverse merger in which MRK would become a subsidiary of SGP. After MRK is technically absorbed, SGP would then rename itself MRK. The tricky part of this acquisition involves Remicade, a rheumatoid arthritis drug sold under a joint agreement between SGP and JNJ, and golimumab, which is pending approval in Europe. SGP and JNJ have a termination clause in Remicade’s marketing plan, which analysts believe could lead to arbitration or a complex takeover situation. Because this deal involves three of IHE’s top 10 components, shareholders should check the headlines for the outcome and subsequent price movement.

Pfizer (PFE), IHE’s second-largest component, has grabbed recent headlines over an ongoing drug test settlement and an upcoming merger. In 1996, PFE tested an antibiotic called Trovan in a meningitis outbreak in Nigeria. In 2007, the Nigerian government claimed that PFE had illegally tested the drug on 200 children, and both the largest state and the federal government filed $2 billion and $7 billion suits, respectively. Also affecting PFE shareholders is the upcoming acquisition between PFE and Wyeth (WYE). The Federal Trade Commission recently submitted a “second request” to review the merger, a step the FTC said was “anticipated as part of the regulatory process.” While the new request might not delay the date of the closing, analysts are watching to see how the deal will affect PFE and WYE share prices. The value of the pending acquisition, a cash-and-stock transaction, will be affected by the price of PFE’s shares.

The proposed rounds of acquisitions could change the face of pharmaceutical industry leadership, something that critics are watching with skepticism. In a Financial Times article published on April 5, Andrew Jack noted that “only one large western pharmaceutical company will be run by a scientist following completion of the current round of acquisitions.” While Jack allows that a marketing and legal background is essential to the leadership of modern-day pharmaceutical companies, he notes that this change is an “evolution” from the scientist-led leadership of the past. While drug research and pipelines are essential to the industry, IHE shareholders should watch for changes in the overall appearance of the industry as marketing and competition surge in a modern marketplace.

Economic conditions play a significant role in shaping pharmaceutical companies and their marketing and development demands. Some studies are urging doctors to pare back on the freebies offered by major drug producers, even as leadership at top drug companies could be pared to non-scientists. Subsectors like pharmaceuticals can be particularly sensitive to industry news. IHE investors should keep an eye to upcoming pharmaceutical mergers and the impact of potential rebalancing in the underlying basket.

Comments

[carey_jim:]

'Andrew Jack noted that “only one large western pharmaceutical company will be run by a scientist following completion of the current round of acquisitions.” While Jack allows that a marketing and legal background is essential to the leadership of modern-day pharmaceutical companies, he notes that this change is an “evolution” from the scientist-led leadership of the past.'

From an eagle-eye perspective, I would see this as a sign that the pharmaceutical oligopoly has entered into it's 'froth' stage and is about to be transformed (or even dismantled) by the government(s).

This is just a tea-leaf reading from a great distance of course, but it seems clear, at least from 'up here.'

Apr 13 12:27 PM