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Many large-cap, name brand pharmaceutical companies with good underlying, fundamental businesses look like good, cheap options in the market today.

Some of the best-known pharmaceutical companies present really compelling statistics and comfortable dividend yields. In an article last week when discussing shipping companies, I focused on “price-to-book value” and “current ratio.” I don’t find it to be very meaningful to compare the book values of drug companies to one another, and there isn’t as much variation among the current ratios of the pharmaceutical stocks under consideration. For that reason, I’m interested in comparing the price-to-earnings (p/e) and price-to-cash flow (p/cf). Good value investors would use their own definitions of these two statistics and do their own calculations based on a review of the companies’ financial reports, but for this post, I’m just using numbers taken from Morningstar.com for the sake of consistency.

Company P/e P/cf
Abbott Labs (NYSE:ABT) 9.3, 8.7
Astra-Zeneca (NYSE:AZN) 8.8, 6.2
Bristol-Myers Squi (NYSE:BMY) 12.8, 10.8
Eli Lilly (NYSE:LLY) 9.7, 5.9
GlaxoSmithKline (NYSE:GSK) 15.7, 8.2
Johnson and Johnson (NYSE:JNJ) 11.8, 9.5
Merck (NYSE:MRK) 8.4, 10.2
Novartis (NYSE:NVS) 10.6, 9.3
Pfizer (NYSE:PFE) 8.4, 15.5
Roche (RHHBY.PK) 12.3, 7.7
Sanofi Aventis (NYSE:SNY) 7.5, 7.7

For comparison's sake, the aggregate p/e ratio of the S&P 500 could be as high as 24 (as reported at here). Keep in mind that the S&P includes all of the companies listed above, so that in order for the average to come out at 24, for every one of the pharmaceuticals described above, there must be one or more high-flying counterparts with an equal weight in the index and a p/e of 41.

I can think of two “behavioral” reasons for these companies to be undervalued in today’s market. First, I believe that one reason stock prices have shot up dramatically over the last six months is the combination of new money and easy credit from federal reserve policies on the one hand and the prospect of declining bond yields on the other. This means that flighty investors with relatively hot money have rushed in to the market for equities, and I believe they have been looking for dramatic high-flyers. The kinds of exciting, fast-rising stocks they are looking for are likely to have smaller market-caps than the companies discussed in this article. Second, I think sentiment is generally down on these companies because of the uncertainty arising from healthcare reform and worries about patent expirations. Both of these issues could dramatically effect the way these companies do business, but to a large extent, I think those concerns are overdone and already “baked in” to the low stock prices.

Two of my favorite stock pickers and capital allocators, Warren Buffet and Jeremy Grantham, also seem to like name-brand drug companies lately. According to Berkshire Hathaway’s most recent 13f, the company owns shares in GSK, JNJ and SNY. GMO-managed mutual funds own shares in ABT, AZN, BMY, GSK, JNJ, MRK, NVS, PFE, and SNY, among others. (My personal favorites right now are LLY, JNJ and MRK, but I can’t articulate good reasons why.)

Because I believe there is value on an industry-wide basis (rather than on a firm-specific basis) and with so many good options to choose from, I think it may also be a good idea to consider an ETF for closed-end fund. Among ETFs, Healthcare Select Sector SPDR (NYSEARCA:XLV) looks like a particularly good choice for an ETF. Almost half of XLV’s holdings are made up of the large-cap drug companies described, including JNJ (13% of assets), PFE (12%), MRK (8%), ABT (4.7%), BMY (3.4%), and LLY (2.8%). XLV also owns a number of medium-sized drug companies, medical device manufacturers, and managed care companies. Expenses are low at 0.21%. Pharmaceutical HOLDRS (NYSEARCA:PPH) also looks attractive. PPH is organized differently from most ETFs with a trust/receipt structure that keeps expenses low but prevents re-weighting. That’s just fine our purpose, because PPH is made up of JNJ (approx. 25%), PFE (18%), MRK (17%), and ABT (10%).

I plan to buy XLV, PPH and LLY over the next few weeks. But because I expect a market correction some time in the next few months, I will save some cash to by more in the future if a better deal presents itself.

It's worth noting that several of the companies discussed, including SNY, NVS, RHHBY, GSK and AZN are foreign companies whose shares trade on U.S. markets in ADRs (American Depository Receipts). Each share you buy actually represents the right to hold shares that trade on an exchange in another country. As such, whenever you buy ADRs, you are paying a price that includes an exchange rate. This may not be a bad thing if you think the dollar is unusually strong against the base currency of the ADR, but a good stock at a bad exchange rate may make for a bad investment overall, so it's worth being careful. My account at Interactive Brokers allows me to trade on foreign exchanges, so last summer when the dollar seemed to have a strong run against the Euro, I bought shares in Banco Santander in ADRs and sold them at a profit at the same time that the Euro strengthened, but this winter with a stronger Euro, I bought shares on the Madrid exchange in Euros. Overall though, I don't think it's reasonable to say that exchange rates are so out-of-whack that you should forego buying any of the companies discussed.

Disclosure: I am long MRK, BRK.B.

Additional disclosure: I may buy any or all of the securities mentioned in the article in the coming days and months.

Source: Value Pharma Stocks in Overpriced Market