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Drug companies have been relatively robust throughout the downturn and could offer diversification benefits. Furthermore, many of these companies also pay attractive dividends that provide current income to investors.

The following biotechnology and pharmaceutical companies will be considered for this article:

Drug Companies

Ticker Name Recent Close (10/4) Market Cap ($ Billions) Forward Dividend Yield
JNJ Johnson & Johnson 62.17 170.4 3.8%
PFE Pfizer, Inc. 17.59 137.2 4.9%
NVS Novartis AG 55.47 134.6 4.7%
GSK GlaxoSmithKline PLC 41.08 104.7 5.5%
MRK Merck & Company, Inc. 31.35 96.6 4.8%
SNY Sanofi-Aventis SA 32.83 86.1 6.1%
ABT Abbott Laboratories 50.5 78.6 4.0%
AZN Astrazeneca PLC 43.99 59.2 6.5%
BMY Bristol-Myers Squibb Company 32.09 54.7 4.2%
AMGN Amgen Inc. 54.35 50.2 2.1%
LLY Eli Lilly and Company 36.73 42.5 5.3%

Source: Data provided by Zacks.com services and Forward Dividend Yield's reflect author estimates.

These companies post forward dividend yields that are substantially higher than the yield from SPDR S&P 500 Trust ETF (NYSEARCA:SPY) which is at about 2.2%. Note that the SPY yield is a trailing twelve months yield. The forward yield could be 5-10% higher depending on the performance of the component companies. This would give an estimated forward dividend yield of about 2.3-2.5%, which is still lower than all but one of the drug companies listed.

The first question to finding the best drug companies for diversification is looking at their historical correlations and volatilities. The correlations are calculated against SPY. Calculating these over a 36 month time frame using monthly prices gives the following table, ranked from highest to lowest correlation. This also shows the volatility of a hypothetical portfolio consisting of 50% SPY and 50% of the drug company.

Correlations and Volatility Reduction

Ticker Correlation Volatility New Portfolio Volatility Volatility Impact
SPY 100% 5.2% 5.2% 0.0%
SNY 72% 7.5% 5.9% 0.7%
PFE 68% 6.7% 5.5% 0.3%
JNJ 67% 4.6% 4.5% -0.7%
NVS 61% 6.6% 5.3% 0.1%
GSK 61% 5.6% 4.8% -0.4%
LLY 56% 6.3% 5.1% -0.1%
AMGN 55% 5.9% 4.9% -0.3%
AZN 53% 6.3% 5.0% -0.1%
MRK 47% 7.0% 5.2% 0.0%
BMY 40% 6.9% 5.1% -0.1%
ABT 33% 5.3% 4.3% -0.9%

Source: Derived from data from Yahoo!Finance Author calculations. New Volatility assumes a new portfolio consisting of 50% of SPY and 50% of the stock. So the SPY new Portfolio is still 100% SPY.

This table shows that JNJ, GSK, and ABT offer the best improvement with respect to reducing portfolio volatility. SNY offered the worse improve, resulting in a more volatile portfolio. However, the next question is to look at the increase in forward dividend yield. Ideally, there will be a stock with great volatility reduction and a good increase in the dividend yield. The following table shows the weighted average dividend (assuming 50% SPY and 50% of the ticker) and the change from a 100% SPY portfolio.

Forward Dividend Yield Change

Ticker Forward Dividend Yield New Yield Change in Yield
SPY 2.4% 2.4% 0.0%
AZN 6.5% 4.5% 2.1%
SNY 6.1% 4.3% 1.9%
GSK 5.5% 4.0% 1.6%
LLY 5.3% 3.9% 1.5%
PFE 4.9% 3.6% 1.2%
MRK 4.8% 3.6% 1.2%
NVS 4.7% 3.5% 1.1%
BMY 4.2% 3.3% 0.9%
ABT 4.0% 3.2% 0.8%
JNJ 3.8% 3.1% 0.7%
AMGN 2.1% 2.2% -0.2%

Source: Author Calculations and Estimates

This analysis shows that AZN, SNY and GSK offered the best dividend improvements, by virtue of having the highest forward dividend yields. JNJ and ABT, which offered great diversification benefits, did not provide much improvement in yield. By comparing the ratio of the new yield to the new portfolio volatility provides a way to pick the best stock for diversification and income. The ranking is in the following table:

Ranking of Drug Companies

Ticker New Yield New Volatility New Yield/New Volatility
AZN 4.5% 5.0% 89%
GSK 4.0% 4.8% 82%
LLY 3.9% 5.1% 77%
ABT 3.2% 4.3% 75%
SNY 4.3% 5.9% 72%
MRK 3.6% 5.2% 69%
JNJ 3.1% 4.5% 69%
NVS 3.5% 5.3% 67%
PFE 3.6% 5.5% 67%
BMY 3.3% 5.1% 65%
AMGN 2.2% 4.9% 46%

Source: Author calculations

This shows that AZN and GSK are the best drug companies for creating additional income and reducing portfolio volatility. However, most drug companies offered an improvement in this area, with the exception of AMGN.

It should be noted that this type of analysis does not consider the valuation of the different stocks nor does it look at the positioning within the competitive market. Additional analysis would be required to determine if any of these stocks were good individual investment opportunities. For example, AZN offered the best diversification and current income. However, if it had a very rich valuation, one might look further down the list and choose another stock that might have a lower valuation.

Disclosure: I am long SPY, GSK.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.