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Pharmaceutical stocks have been rallying of late, buoyed by news of richly priced mergers, including Roche's $44 billion bid for Genentech (DNA) on July 21 and the $7 billion offer by generic drugmaker Teva Pharmaceutical Industries (TEVA), a few days earlier, for rival Barr Pharmaceuticals (BRL). But it's not just consolidation that's drawing investors to drug stocks. Even in the face of unprecedented challenges, ranging from patent expirations on billion-dollar products to an increasingly tough regulatory environment, investors keep piling in. On July 15, the market value of health-care stocks in the Standard & Poor's 500-stock index exceeded that of financial-services firms for the first time since 1992. The American Exchange Pharmaceutical Index is up 4.1% since July 1, while the S&P 500 has dropped 1.7%.

But amid this pharmaceutical frenzy, investors got a sobering reminder of just how risky it is to be investing in drugmakers. On July 21, Schering-Plough's (SGP) shares—which had rallied 35% in the prior three months—plunged 12% on news that its embattled cholesterol drug Vytorin performed poorly in a clinical trial. The news also pushed down shares of Merck (MRK), which co-markets Vytorin.

The share declines underscored the risks of flocking to pharmaceutical companies as safe havens in bear markets. Investors often favor drugmakers as an alternative to battered sectors because people generally don't stop taking their prescription drugs when their pocketbooks get squeezed. Most large pharmaceutical companies have healthy cash flows, and they pay generous dividends, even in the worst of economic slumps. What's more, investors can make out fabulously when they place bets on companies that are strong takeover targets: Roche offered a 9% premium over Genentech's previous closing price, while Teva offered to pay 43% more than where Barr's stock had been trading.

Unfounded Reputation for Stability?

The drug industry's safe-haven status is coming into question, as even the most basic assumptions about its stability are proving untrue. In the second quarter, the number of prescriptions fell for the first time since the mid-1990s. Polls show that because of rising health-care costs, patients are more apt to skip doses or cut their pills than they were three years ago. And nearly one-quarter of patients report not filling a prescription because of expenses, says the Henry J. Kaiser Family Foundation.

Add in the long-term threats to the industry, and it starts to look as if cash or perhaps U.S. Treasuries might be a safer investment than drugs. Some of the biggest industry names are facing daunting patent expirations. Pfizer (PFE) will lose its $13 billion-a-year cholesterol blockbuster, Lipitor, to generic competition in 2011. Bristol-Myers Squibb's (BMY) powerhouse blood thinner Plavix, with $5 billion in sales, goes off patent that same year. Merck already lost patent protection for its $3 billion osteoporosis drug, Fosamax, earlier this year.

Drug companies are trying desperately to come up with substitutes for these big products, but even there, Big Pharma is struggling. Part of the problem is that the Food & Drug Administration has become increasingly picky and cautious. The federal regulator has been rejecting more drugs because of safety concerns or a lack of compelling evidence that they represent a true advance over what's already available. In April, Merck suffered two FDA rejections in three days, including one for a cholesterol drug that analysts had predicted would be a blockbuster.

"In terms of generic exposure and the success of the pipeline, it doesn't look great," says Herman Saftlas, a pharmaceutical analyst for Standard & Poor's, which, like BusinessWeek, is owned by The McGraw-Hill Companies (MHP).

Cost-Cutting: Not a Long-Term Fix

History shows that even the dividend isn't sacred in this industry. In 2003, Schering-Plough CEO Fred Hassan slashed the company's dividend to 22¢ a share from 64¢ as part of a turnaround strategy. (The dividend is now 26¢ a share.) Investors were none too happy, and those who have stuck with Hassan have been on a sickening roller-coaster ride. Their shares returned nearly 60% by mid-2007, but then went into a free fall earlier this year, when a study suggested Schering's cholesterol drug Vytorin may be no more effective than cheaper alternatives.

Prior to the recent second round of bad Vytorin news, Schering had been rebounding partly on the success of Hassan's cost-cutting initiatives. Most pharmaceutical companies have spent the last few years slashing sales personnel and implementing efficiency plans to prop up earnings. But there's only so much cutting they can do; slimming efforts may only benefit shareholders in the short term.

Safety in Diversity

Is anything in this sector truly safe? Analysts recommend companies such as Johnson & Johnson (JNJ) and Abbott Laboratories (ABT), which are diversified well beyond prescription drugs. On July 15, J&J beat earnings estimates, thanks in part to a 13% jump in sales of consumer products and over-the-counter drugs. J&J's hit products include Listerine, Tylenol, and most recently, Zyrtec, an allergy drug the company converted from prescription to over-the-counter. Stephen O'Neil, an analyst for Hilliard Lyons, writes in a report that he expects J&J to trade at a 15% premium to the S&P 500 "due to its diverse business, high returns, and strong financial condition." He adds that "no one product or business is likely to dominate [the company's] results," helping it to weather disappointments in its medical devices and drug units. Johnson & Johnson's stock has returned 3% this year. The S&P 500, by contrast, has lost 16%, and the S&P 500 Health Care Index is down 10%.

More merger-and-acquisition activity might fuel rallies in some companies' shares. Picking the right targets could be a challenge, though. Even though Roche had long owned a majority of Genentech's shares, few expected the Swiss giant to swoop in and buy the rest, because European executives there swore they preferred to maintain an arms-length relationship with the South San Francisco (Calif.) biotech. Barr, on the other hand, was a more obvious takeover target; the generic drugmaker's shares had lost 23% of their value in May amid fallout from a surprisingly bad earnings report.

Barr serves as yet another reminder of how one piece of bad news can change virtually everything for a drugmaker in a flash. In a storm, the drug sector may be a beacon to risk-tolerant investors. But a safe haven it's not.

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