Potential for Huge Profits Awaits Big Pharma Companies

Includes: BMY, GSK, PFE
by: Jack Miller

Peak production of Comstock Lode silver was in 1877. This vein of silver, located in the mountains north of Reno Nevada, was the granddaddy of all US Silver veins. (Virginia City of Bonanza fame was the mining town that built up at the base of the mountain.) Ultimately, more than $500 billion dollars worth of gold and silver (inflation adjusted) were pulled out of those hills. The first several groups of men to prospect the area made money but they all moved on to California because they heard about the big strikes there. Later, one of the first two men who realized the vein was huge suffered leg amputations and death and the other suffered a leg amputation, near death and the loss of his friend. He lost his motivation to seek treasure and went back home.

Henry Comstock discovered the empty cabin of the "founders" and was prospecting the area when four others found the main vein. Henry had the good sense to stake a claim on the adjacent land. He weaseled his way into a 10% partnership share that would have been worth millions but he sold it for $8,500 on the belief that such a tidy sum would put him in good stead until he could find another big strike. He reminds me of the way most stock investors trade.
Big pharma companies are also somewhat like Henry Comstock, they constantly look for the next big strike. The search can seem to be endless. The peak in drug stock share prices was about 10 years ago. For example, Glaxo Smithkline (NYSE:GSK), which traded higher than $72 per share in 1998, trades for around $43 today. The share prices of other big names such as Bristol-Myers Squibb (NYSE:BMY) and Pfizer (NYSE:PFE) have followed similar fates. The good news is that there are a number of reasons to expect an upturn. Indeed, it appears that the upturn has already started.

The economy goes through cycles of good times and bad times. We are currently at or near a peak in food and fuel prices. Food staples and even gasoline are "Giffen Goods". Giffen Goods are strange in that when the price goes up, the demand, at least for a while, goes up. This is contrary to intuition and to basic laws of economics, but true.

Many Americans have lost all feel for what it is like to be poor. The poor understand the way Giffen Goods work. The poor man spends a large percentage of his income on food and fuel. The poor man eats a lot of staples, such as rice, beans and corn, but he hungers for protein and eats meat when he can. When the price of food goes up, he is forced to cut out the meat and eat more of the Giffen Goods. The good news is that this action is ultimately self correcting because the reduction of grain consuming herds later cuts back the demand and price of the grains.

When the price of fuel goes up, the rich man can afford to take a loss on his big SUV. He buys a second vehicle to leave the SUV fallow or he trades the SUV. The poor man buys what he can afford which is the old fuel guzzler. The poorest man might even get a free or almost free vehicle from Goodwill, but it will be a gas guzzler.

Drugs are not Giffen Goods. When the price goes up, the quantity consumed generally goes down. I am sure you have heard the lament of the politicians who love to use the example of the poor old lady who cannot buy her medicine because she has to buy food. The point of these words is not to lambaste the drug companies. Drug companies have given billions of dollars of drugs to the poor. The point is that while we are in a tough time for "luxury drugs", these tough times will not last.

Today, almost every food product is grown almost year round in one location or another. If price of corn is high, the chances are good that extra corn will be planted very soon in the northern or southern hemisphere. It will not be long before there is an excess of grain that must be stored until the market can adjust in the other direction. Back in the days when American farmers were too poor to store grain, it made sense for the government to provide price support programs. Today, the US government buys excess production from very rich farmers.

I think it was Ken Fisher who posted a chart a couple of years back showing that the US economy grows more than 95% of the time and that it grows most quickly after economic slowdowns. Good times follow bad times and in good times, even the poor will buy high priced medicines. In good times, modest improvements to a drug can turn it from a low profit margin commodity to a hot selling high profit wonder drug.

McCain has proposed a health care plan that would once again give the drug companies hope. His words about big companies are not so positive but his policy proposals are generally fair.

The potential for huge profits await the drug companies. The battle to enforce intellectual property rights is strengthened by the rise in prosperity of peoples around the world. Billions of people will see significant increases in disposable incomes just as their parents reach the age when many drugs are needed.

During the peak of the silver and gold rushes, a lot of savvy traders head faked their way to fortunes. Traders would spread stories of fires or floods in mines in order to accumulate shares cheap or they would spread stories about which rich owner was buying in order to sell shares at a premium. One web site shows a picture of Samuel Clemens (Mark Twain) with the caption that he was paid to write exaggerated stories about the mines.

Today, the media is so eager to sell stories that it unwittingly aids and abets the head fakes of the rich and powerful. It was all over the news yesterday morning that Warren Buffet bought shares in Unitedhealth Group (NYSE:UNH) and more shares in Burlington Northern (BNI). Based on the business cycle, it is time to buy shares in Burlington Northern, to sell shares in health care providers and to buy shares in drug producers. Who is willing to argue with Warren Buffet?

A careful reading shows that Warren has accumulated large positions in the rails so the Burlington story was old news. UNH might be a good buy as it has fallen sharply from its peak, however, I don't think it is such a big deal for a stock that has increased in value 24 times in 15 years or so and about 60 times in 35 years to fall 30%.

If Warren does not accumulate a huge position in UNH, it will not be the first time that he has pulled a head fake. Indeed, for Warren to accumulate a substantial position, he must shake at least a few followers off his tail. For example, he was able to accumulate a huge position in the rails only after a number of head fakes and, thus, after his flock of followers was diminished.

It is hard to prove which goods are Giffen Goods. After all, it is easy to show that the cause of the increase in the price of rice was a result of higher demand just like any other good. It is hard to prove that the rise in demand was caused by the rise in price. The classic mistake, made by Al Gore, is to assume that a cause and effect exist where there is only a correlation.

This morning the housing construction numbers soared due to a sharp rise in apartment construction. While the top stories have all been about the excess of housing, rents have been rising. The Giffen Good concept helps make sense about the rise. The poor, who can no longer afford the payments on a big house, are in the rental market. The higher the rental rates go, the more demand there is for the lowest quality of goods. Like the beat up old SUV that the rich no longer wants, the small apartment is in demand. In many a case, the family who loses a high dollar home to foreclosure will move into a "low" rent apartment. The rental rates for the lowest dollar apartments are the ones that are rising the most in percentage terms.

Prepare for even more populist whining. Politicians continue to try to make hay off of short term phenomenon while ignoring the long term benefit. Investors should look way out over the horizon. The time to buy drug shares is when the price is down and when the price of Giffen Goods is soaring. Those who move from the big home to the small apartment will soon discover a huge jump in their disposable income. Then as the commodity spider builds its web, the price of food and fuel will fall. Consumers will have the extra cash to buy every thing from Game Boys to cancer cures.

BMY hit bottom on March 17 at 20.46 per share. It closed yesterday at 22.08 per share. It pays almost a 6% dividend. It should be bought, put away and forgotten.

If you cannot see the turn, take a look at the "resource currencies" of Australia and Canada. These countries are rich in natural resources and their currencies climbed for the past 8 years. In recent weeks, these currencies have faltered. Yes, the demand from India and China has been extremely strong for a very long time but the 2.7 billion people in these countries are hungry for more than a few consumer goods. They are hungry for heath cures. The reason 14 million electric and 12 million gasoline powered scooters will be sold in China this year is because the people wish to satisfy other needs.

My story has made too much of Giffen Goods. The concept is valid but the business cycle is the powerful force. As we move into the second half of the business cycle, the demand for higher quality goods will prevail.