Risks aside, drug makers lure defensive investors

By Lewis Krauskopf - Analysis

NEW YORK (Reuters) - Setbacks for several large drug makers last week underscored the risks of the pharmaceutical sector, but they failed to spook stock investors who see the industry as a safer bet in rocky economic times.

U.S. drug maker Schering-Plough Corp SGP.N looked like anything but a defensive investment when its shares slumped about 20 percent after a failed study for its big-selling cholesterol treatments was released on Monday.

Merck & Co (MRK.N), Schering's partner on the drugs, also took a hit, as did Swiss company Novartis AG (NOVN.VX), which on Thursday posted disappointing quarterly results and indicated a highly anticipated diabetes medicine may never reach U.S. markets.

Such product stumbles have played a consistent role in hurting global drug stocks, which on average have badly underperformed the broader market over the past five years.

But the drug sector -- with its strong dividends and profit margins -- still presents an appealing defensive investment because consumers are likely to continue to purchase medicine even if the economy worsens.

"It does look like companies that have less sensitivity will outperform the market from an earnings and revenue standpoint, and in turn that should drive their stocks," said Ben Halliburton, chief investment officer for New Jersey-based Tradition Capital Management, which is overweight in healthcare.

Over the past three months, the American Stock Exchange Pharmaceutical index .DRG, a barometer of large global drug companies, has fallen only about 4 percent compared with a 14 percent drop for the S&P 500 .SPX. The relatively better performance has continued so far in 2008.

Profits also look relatively more promising for pharmaceutical companies over the next year, said Ruairi O'Neill, senior equity research analyst with PNC Capital Advisors in Philadelphia.

"Over the next 12 months, (earnings per share) revisions for pharma on a relative basis will look better than the S&P 500 overall, so from that perspective it should be more defensive," O'Neill said.

Further, investors point to favorable demographics for drug companies, with a growing aging population that will demand more medicines.

"Everything has gotten really hit and if you look at the healthcare sector as a whole, and Big Pharma in the midst of that, it's holding up remarkably well," said Andrew Bischel, chief investment officer at SKBA Capital Management in San Francisco.

To be sure, pharmaceutical companies overall have been a poor bet during the bull market of recent years. The Amex Pharmaceutical index is up only about 12 percent since the start of 2003, far behind a 50 percent rise for the S&P 500.

The sluggish performance reflects fundamental worries about the drug industry, including lack of research productivity, brutal competition from low-cost generic drugs and tough regulatory hurdles for winning approval for new medicines.

Knott Capital, a Pennsylvania-based investment advisory firm, is overweight on healthcare but underweight on the pharmaceutical industry. It holds only Novartis among large drug makers, said portfolio manager Peter Schofield.

A U.S. advisory panel's rejection last year of a Genentech DNA.N drug for treating breast cancer fueled worries that regulators were raising the bar for companies to get their products approved, Schofield said, compounding industry problems with research pipelines and generic competition.