I actually wrote the below in an article for FT in 2005 but, after reading the news that Pfizer (NYSE: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 (Pending: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