(Corrects Pfizer dividend in 23rd paragraph.)

March 9 (Bloomberg) -- Drug stocks are supposed to hold up well during recessions and bear markets. Until last month, they did.

From June 30, 2008, through Feb. 6, 2009, the pharmaceutical group within the Standard & Poor’s 500 Index declined 5.7 percent, taking dividends into account. By contrast, the S&P benchmark dropped 31 percent.

That made sense. People generally keep taking medicine, even during hard economic times. Many investment managers, myself included, put a chunk of their clients’ money in drug stocks expecting the group to be a haven amidst the market carnage.

Since early February, however, shares of drugmakers have sunk roughly in synch with the overall market. And in the past couple of weeks, they’ve done worse.

For the 30 days through March 6, the drug group as a whole dropped 18 percent. The biggest loser was King Pharmaceuticals Inc., down 42 percent. Eli Lilly & Co. fell 31 percent. Pfizer Inc. declined 28 percent. And Merck & Co. was down 25 percent.

Investors generally blame the sector’s drop on the Obama administration. They fear that the federal government will press for punier prices on drugs purchased by Medicare and Medicaid, be excessively strict about approving new drugs, encourage the growth of generics, and tax more of the profits earned by big pharmaceutical makers.

Strong Buy

Each of these fears is justified to some degree. But overall, I consider drug stocks a strong buy.

If you don’t already have pharmaceutical stocks in your portfolio, the past month’s plunge gives you an opportunity to add them.

What do I like so much about these stocks? To begin with, drug companies make products that save lives and ameliorate suffering. Yet the stocks sell for less than nine times earnings -- slightly less than the price-earnings ratio for tobacco companies, whose products do neither.

Many drug stocks have been declining for a half-dozen years. That’s a long time, and I believe their prices have already declined enough to reflect the problems they face -- a scarcity of new blockbuster drugs, a spate of patent expirations, tougher competition from generic drugs, and stiff resistance by government agencies and insurers to paying high prices.

Merck, for instance, exceeded $88 a share in late 2000. Today its shares trade for less than $24.

Drug Pipelines

Pfizer, the largest U.S. drugmaker by stock-market value, reached $48 in mid-2000. It now trades below $13. Its leading seller, the cholesterol-reducing drug Lipitor, will go off patent soon.

Pfizer isn’t the only drug company about to walk off a “patent cliff.” Many other big drugs go off patent in the next two years as well. Critics worry that drug companies’ new-product pipelines are almost empty. My own view is that the pharmaceutical companies haven’t lost their research prowess, and that it isn’t always clear in advance which drugs will be blockbusters.

Have the profits of these giant drugmakers collapsed? Far from it. Merck earned $6.8 billion in 2000. In 2008, amidst a raging recession, it earned $7.8 billion. Earnings have risen, yet the stock price has been sliced more than 73 percent.

Some of the recent declines have come on company-specific news. For example, King’s patents on its muscle relaxant Skelaxin, its biggest selling drug, were found invalid.

Morphine Capsule

Its experimental morphine capsule Embeda hasn’t won regulatory approval as quickly as hoped. The company is eliminating about 760 jobs, or about 22 percent of its workforce.

Other news affected several companies at a time. At an AIDS conference in Montreal on Feb. 9, Danish researchers suggested that AIDS drugs made by Merck, Abbott Laboratories and Glaxo SmithKline Plc have a side effect of increased heart-attack risk.

But for most of the drug group, it was the broader political and economic climate that hurt. President Barack Obama told Congress he wants to make radical changes in the health-care system. Investors get nervous when they don’t know what rules they’ll play under.

Unlike the Bush administration, the Obama team favors importing drugs from abroad. Under President George W. Bush, the Food and Drug Administration argued that such a step would compromise safety, as foreign drugs aren’t inspected as carefully as U.S. drugs are.

Undeniably, though, importing drugs could help control costs -- and that has been identified as a key goal by President Obama.

Ignoring Good News

My disagreement with drug-stock detractors isn’t that I think their arguments are wrong. It’s that I think they are ignoring most or all of the good news.

Merck, for example, had a 30 percent return on capital and a 42 percent return on equity in 2008, a recession year. Compare that to a 39 percent return on equity for Exxon Mobil Corp. and 27 percent for Apple Inc. Those are cream-of-the-crop companies.

Then there are the dividends. Pfizer has a dividend yield of 5 percent, even after slicing its dividend in half last month. Eli Lilly yields 7 percent, and its $1.90 annual dividend looks reasonably secure to me. Merck yields 6.7 percent, and I think it can keep up its $1.52-a-share annual payout.

Considering that a normal stock in a normal year averages total returns 9 percent to 10 percent, these generous dividend yields take you a good part of the way. The dividends also act as an anchor, helping to preserve the stocks’ value if markets remain in turmoil.

Disclosure note: Personally and for clients, I own shares in Merck, Pfizer, King Pharmaceuticals, and AstraZeneca Plc.

(John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own. His firm or clients may own or trade securities discussed in this column.)

To contact the writer of this column: John Dorfman at jdorfman@thunderstormcapital.com.

Last Updated: March 9, 2009 08:44 EDT