For a brief moment, when the Labor Department reported that god-awful July jobs number showing an Uh-oh deceleration in the economy, you saw investors reach for the drug stocks. For decades, when the economy softened, when a recession beckoned—as it surely does now—Big Money has bought Big Pharma because nothing’s more recession-proof than drug-company earnings. Regardless of whether you are employed or out of work, you have to take, and pay for, costly medicines.
And then saner heads prevailed, the heads that realized that if this economy can’t create more than 32,000 jobs per month in an election year, a new president—one even less healthy for the drug companies than the current one—might inhabit the White House five months from now. Immediately, these once-loved equities sank like the stones they have been all year.
Rarely in all of the 25 years I have traded stocks—including the years of the aborted Clintonista health-care plan—have drug stocks been as cheap as they are now. They trade at multiples to earnings—Wall Street mumbo-jumbo for relative-valuation yardsticks—that resemble those you typically get for an Alcoa or a Dow Chemical or other former growth businesses that are now totally hostage to the vicissitudes of the U.S. economy. Despite their “cheapness,” they can’t lift on good days and they go down harder than the market on bad ones. And if the election stays close, or if anyone believes for a moment that the Democrats will gain control of Congress, they will continue to trade even lower, perhaps much, much lower, right through to Election Day, because this industry has become public enemy No. 1 for the Democrats. And a Bush win hardly portends an instant cure. The Republicans, who see the same poll numbers, the ones that show big drug companies as less liked than even pump-gouging multinational oil companies, aren’t about to stick their necks out to save pharma either.
Don’t get me wrong. I love these companies. They are fantastic innovators that have created life-saving drugs—and thousands of jobs—for years. They are among our most valuable industrial jewels, worshipped by portfolio managers since the bull market began in 1982 for their fantastic growth and predictability. So how did they become the whipping boys of both parties, and Main Street and Wall Street? Why, after years of fending off pricing regulation through intensive lobbying and political donations, have the drug companies at last been dealt a losing hand in Washington?
“How did these companies become the whipping boys of both parties, and Main Street and Wall Street? First, they deserved it.”
First, they deserved it. These companies have put through price increase after price increase year after year to meet the promises of double-digit growth they have repeatedly made to Wall Street. Their inability to create new, blockbuster drugs has caused them to rely on those increases to make the estimates they live by. When they can’t make the estimates, it seems they stuff the channel with product (as the SEC recently alleged Bristol-Myers did; the company didn’t admit guilt, but it settled the case earlier this month), or effectively give kickbacks to insurance companies, as Schering-Plough just pleaded guilty to doing. (Both companies agreed to pay gigantic fines for their shenanigans.) Drug companies have also acted terribly when their products come off patent, doing everything they can to fool the consumer into continuing to pay higher prices for so-called new formulas that aren’t really new at all. They’ve also constantly sued generic manufacturers to block the introduction of copycat drugs after the patents expire.
Second, with the big Medicare benefit just passed, the federal government will soon be buying 50 percent of the nation’s drugs, up from 16 percent currently. It’s true that the Feds don’t negotiate directly with the manufacturers to get bargains (which, of course, is just plain stupid, but the drug lobby won out on the issue). But if Kerry comes in, and Congress changes hands, you can bet that law will change. The result would be prices reduced by 50 percent for many, if not most, drugs. That would be cataclysmic for drug companies’ earnings, and even though the stocks have taken a beating, they are nowhere near reflecting such an earnings crunch.
Third, the drug companies are the easiest link in the health-care chain for the Feds to beat up on, something that’s necessary given that 14 percent of the GDP is now health care, 46 percent of that spending is done by the Feds, and health-care costs are rising faster than all other costs. It’s much harder for the Feds to rein in the cost of hospitals or the cost of the caregivers than it is to control the prices of the drugs the Feds buy. Even though pharma pricing represents a much smaller percentage of the federal health-care budget than do these other elements, the drug companies have failed miserably at explaining to the public why their products cost so much, especially when they cost so little in other countries. Surveys batched by broker Sanford C. Bernstein & Co. in a recent cautionary report about pharma stocks spotlight the issue starkly: Drug costs rank above corporate misconduct and the federal budget, voters say, as a source of their economic woes; most adults fear they won’t be able to afford new drugs; and 73 percent of adults say prescription drugs are a key factor in how they intend to vote. Worse, polls show over and over again that most voters simply don’t understand the value proposition of life-saving drugs—that the companies should be able to recoup the cost of R&D over the twenty years of a patent’s life. In other words, the public despises the drug companies, no matter how many life-saving ads they bombard us with.
Finally, the drug companies have been their own worst enemy, headline-wise, of late. Hardly a day goes by when one of them isn’t accused of hiding negative data about antidepressants and teenage suicide, or exaggerating the claims of the patented anti-congestive-heart-failure drugs versus generics, or understating the side effects of expensive anti-arthritis drugs.
So what should you do? To use the methodology I employed successfully for years at my old hedge fund, I’d short these stocks into the oblivion they are headed to, and I wouldn’t cover until the week before the election (by that point, health stocks should all be so thoroughly discounted for the worst-case scenario that it won’t matter who wins; they will all rally). And then I would sell them again, because under Bush or Kerry (and especially under Kerry)—with the government now buying such a large portion of the nation’s drugs, with price controls and the concomitant dramatic reduction in earnings—this sector is going to get sicker before it gets well.