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When the stock market was rallying into the summer of 2011, one of the explanations that commentators gave for the run up in valuations was the abnormal spread between the risk free rate and the earnings yield on the S&P 500. At the time, I contended that the run was concentrated amongst a few names, so that theory did not apply. However, now that valuations have been reset, and the S&P 500 is 12% off its high, it may be time to revisit this theory.

The large pharmaceutical and medical technology companies are in similar situations. For many years, they both benefitted from a run up in spending on healthcare, novel therapies, consolidation and pricing power. However, since the recession started in 2008, healthcare organizations have been under fire to control costs as the government, which makes up at least 40% of healthcare spending, looks to rein in deficit spending. Additionally, as admissions have declined in the acute care setting, hospitals have been putting pressure on all non-proprietary products to gain better pricing in a tough environment.

In response to declining prices in legacy categories, most companies in the industry have gone through multiple rounds of layoffs and have consolidated factories. Additionally, companies have been restructuring their product portfolios by purchasing product lines with promising growth prospects and selling product lines with low to no growth.

There have been a good deal of examples of late that show the degree to which pharmaceutical and device companies are attempting to attain a higher multiple from investors. Earlier in the year, Pfizer (NYSE:PFE) announced an initiative to put its non-core businesses up for sale in order to focus on proprietary pharmaceuticals. Abbott Laboratories (NYSE:ABT), a company which relies heavily on profits from its key drug Humira, recently announced its plan to split the company in two between proprietary pharmaceuticals and diversified medical products. Gilead (NASDAQ:GILD), a company whose patent life on its primary products runs out within 7 years, was widely thought to be a target for acquisition until it announced its bid of over $11 billion for Pharmasset (VRUS), a company with a promising pipeline of HCV drugs.

The idea was that if Gilead didn’t add a component to its product pipeline, its stock would have been doomed to trade at a sub 10x multiple for the foreseeable future. Another takeout candidate, Medicis (MRX), faced patent expiration over the next 12 months. Instead of selling out to another company, management decided to put a significant portion of cash on its balance sheet towards the purchase of the assets of bankrupt Graceway pharmaceuticals.

All of the above are examples of how companies are attempting to refocus their efforts on proprietary pharmaceuticals. Typically, if investors see top line growth, they will reward companies with a greater multiple. Additionally, while the risk free rate is below 3%, the dividend yields on many of the companies in the industry are significant. Only time will tell how this story plays out, but looking across the large cap healthcare space, it appears that valuations are compelling enough to start taking notice. If investors decide that it is again in style to purchase companies in the sector in hopes of lucrative product pipelines, stock prices could rise, most accompanied with a dividend.

Company

2012 Price to Earnings Ratio

Dividend Yield

Abbott Laboratories (ABT)

10.5x

3.07%

Covidien (COV)

9.5x

2.0%

Johnson & Johnson (NYSE:JNJ)

12.0x

3.7%

Medtronic (NYSE:MDT)

9.5x

2.9%

Merck & Co. (NYSE:MRK)

9.0x

4.6%

Pfizer (PFE)

8.5x

4.3%

S&P 500

11.5x

2.20%

Disclosure: I am long MDT, MRK.