Healthcare: Branded Pharma Out, Diagnostics / Generics In

When you lose, Don’t lose the lesson - The Dalai Lama

For the better part of 5 months I’ve been kicking myself over not dumping Pfizer (PFE) from the Secular Trends Portfolio the day they announced the Wyeth merger. The second I heard about the deal I honestly thought the TV announcer had made a mistake; “No no, it couldn’t be Wyeth. That would just be stupid”

The sad part is if you read my September 08 post from when I added Pfizer, I got exactly what I wanted:

I am hoping they announce an acquisition before early January, because this position may be out the door by then…

Ah, if only I had remained true to that conviction. But I was not overly bullish on the market at the time (which was quite true until March), and felt that the low valuation and yield on the PFE might lead to outperformance relative to our benchmark.

I was wrong to the tune of about 13% - relative to the S&P - since the merger was announced in January. The key lesson here for me is to remain steadfast to the core tenets of the Secular Trends Portfolio; when something changes my thesis for the foreseeable future, get out - immediately. My desire to keep turnover figures from looking like the average stock fund (figure between 60-75%) is no excuse to create a nagging voice of self-criticism for months on end.

The only way Pfizer could become an attractive stock again is if it slashed its marketing & promotional expenses (and delivery model army) by about, oh, say 90%. A trend towards this is bound to occur with the seemingly inevitable passage of comprehensive healthcare reform, but knowing Pfizer they will move like a snail and it will drag on their returns for several years.

It’s a shame….Pfizer had so much balance sheet strength and a once-in-a-lifetime opportunity to snap up some cheap rivals with actual pipelines. Instead they leveraged it all to go out and get….someone just like them. Horrible strategy, no matter how much in cost savings they can wring out of the acquisition.

Selling 3100 shares PFE @ $14.53:

My Shiny New Healthcare Strategy

For the moment I’m still holding on to the Bristol Myers Squibb (BMY) position, as the valuation and yield are even more compelling than Pfizer was at the beginning of the year. But it may find itself on the chopping block soon, as the market doesn’t seem to be giving strong balance sheets and safe dividends any real respect this year. To its credit, the BMY position has provided me with about 15 points of alpha since its addition.

Outside of that, I’m taking things in a new direction. Branded pharma is simply too dangerous a proposition. My new focus is on leading generic companies and diagnostics. As to the latter, I’m interested in both “throwaway”, low-margin diagnostics, and advanced life sciences diagnostics. The addition yesterday of Beckman Coulter (BEC) is a blended play, as the company has exposure to both with a nice foothold in key international markets.

Diagnostics are attractive in several respects. First, balance sheet strength and valuation are both good industry-wide. Second, as explained above, you can quite easily get as high-tech or low-fi as you wish. On the ultra high-fidelity front, I’m quite attracted to Life Technologies Corp. (LIFE) (formerly Invitrogen), which seems to be beating the snot out of its competitors.

And finally, China has its own healthcare reform program in place, and just like with their stimulus package this year you can expect their dollars & yuan to get moving quickly and forcefully. The size of the program? $123 billion to be spent by 2011, much of that going to rural areas in the form of 5000 clinics, 2000 hospitals, and 2400 urban community clinics. Let me say there is no hyperbole when I estimate that the entire $123 billion might be spent before the U.S. gets the first dime of its version to its intended destination.

China has a whole different viewpoint on medicine, so there are also opportunities to pick up some targeted names in “Traditional Chinese Medicine”, but few that are investable to Western retail investors. I’ll update readers on this trend as I dig deeper into the world of roots, herbs, and funny little needles.

Generics Thesis

I watched some footage on C-SPAN yesterday of President Obama; he was speaking in a town-hall setting about his aims for healthcare reform (which, by the way, is a near certainly now that there are 60 votes in the Senate). He made multiple, specific mentions of personalized medicine and increased use of generic drugs. You can watch the ~1 hour video of Obama here.

Trying to figure out exactly how the future healthcare landscape will look is more than just a daunting task.

For starters, it’s out of my intellectual wheelhouse; trying to assess branded pharma stocks is difficult enough without an M.D., and even if I had one, it would (at best) only give me insight into a narrow band of stocks. The rest of the industry is a maelstrom of dangers, quarks, and other unpredictable events.

Investing in generics may involve some of the same challenges, but it’s much more dependable, as much of the legwork has already been done. Yes, the margins will never be as good, but margins are coming down across the industry, period. It’s just going to be the way of things. It doesn’t spell doom for branded pharma; just look at how depressed the multiples have been for the drug stocks with the biggest R&D budgets in the world. Not a one of them has sprouted above 14-15x in more than a decade. This is proof enough for me that the risk/reward balance hasn’t been in their favor for some time, juicy margins or not.

So with all the common sense “future vision” I can muster, I see generics getting more favorable attention & market share in the next decade than they have ever received. Add that to the tens of billions in soon-to-be-off-patent brandeds, and some powerful secular trends emerge.

I don’t know exactly which generic stock I will choose, but one will be added to the model portfolio shortly. Leading candidates are currently Mylan (MYL), Watson (WPI), TEVA (TEVA), and Dr. Reddy’s Labs (RDY). The last two are foreign-based, and while I don’t foresee any blatant protectionist measures in the healthcare bill, knowing the nature of our Congress I would lean toward investing in a domestic name first. There is a whole slew of blended plays (such as Forest Labs (FRX)) that deal in both smaller-market brandeds and generics; they will also be analyzed but the fundamental metrics would have to be stellar for me to take the extra risk in this environment.

Given the weak volumes & poor jobs data today heading into the holiday weekend, I’ll likely wait until next week to make any more additions to the model. For those of you trying to get out of the office early today, best of luck, and have a great Independence Day.

Disclosure: author does not hold positions in the companies mentioned; BMY and BEC are held in the Secular Trends Model Portfolio