Drug Stocks To Watch In '96

If you were looking for market action in 1995, pharmaceutical stocks were just what the doctor ordered. U.S. health-care reform died, and with it fears that drugmakers would see their revenues sharply limited. Plus, widespread cost-cutting in the industry helped turn profits around after a slump in 1994. The sector also saw a wave of megamergers, starting with the $14 billion combination of Britain's Glaxo and Wellcome in January and winding up with the widely praised marriage of Sweden's Pharmacia and the U.S.'s Upjohn.

HEADY RETURNS. All that news pushed global pharmaceutical stocks through the roof: In the U.S., the group outperformed the Standard & Poor's 500-stock index by 18 percentage points, and in Britain, the pharmaceutical sector returned 19 percentage points more than the benchmark Financial Times-Stock Exchange 100 index.

That's a tough act to follow, but some experts think more gains could lie ahead. The difference this year, says Richard Vietor, a first vice-president at Merrill Lynch in New York, is that "earnings growth will shift from cost-cutting to fundamentals." That means investors may want to focus on companies with significant new products.

In the U.S., Merck's Fosamax, an osteoporosis treatment, and antihypertensive Cozaar both received Food & Drug Administration approval in 1995 and are getting positive early reports. Pfizer is expected to launch four drugs from 1996 to 1998, including Zyrtec, a low-sedating antihistamine that received FDA approval last month. Such innovations are expected to push their creators' earnings growth rates above the average 7%-to-10% that is being forecast for the industry in 1996.

In addition, while the pace of consolidation is bound to slow--if only because fewer takeover candidates remain--the merger trend among drug companies isn't over. Glaxo Wellcome, the world's biggest drugmaker, still has only 6% of the global market. So, many industry watchers expect combinations to continue until only 10 or 15 giants are left. Among American takeover targets, the biggest unknown remains closely held Warner-Lambert. Its shares are up nearly 14% since July, despite a forecast earnings decline for 1996, on merger speculation.

Takeover plays aside, analysts believe that there are enough drug stocks with upside potential left to build a healthy portfolio. Switzerland's Sandoz is widely recommended as it continues to divest noncore assets--"changing its spots and focusing on what it does best," says Salomon Brothers analyst Peter Laing. Also, Sandoz' pipeline includes the Alzheimer's drug Exelon, for which the company is expected to seek FDA approval by the end of 1996.

Sweden's Astra also gets high marks, in part because its stock is relatively inexpensive. "Astra looks like one of the most undervalued [drug] companies in Europe," says Kevin Scotcher, who follows the pharmaceutical industry for Kleinwort Benson in London. Its projected price-earnings ratio of 20 compares with a starry 37.5 for industry highflier Roche. Another plus: The patent for Losec, Astra's ulcer medication, doesn't expire until 2004--six years after the first patent on Glaxo Wellcome's competing drug, Zantac, runs out.

SLEEPERS IN JAPAN? Although most investors have chased the hot transatlantic drug-industry action, some stock-pickers think the real sleepers are in Japan. Samuel Isaly, manager of Capstone Medical Research Fund and a partner at industry analyst Mehta & Isaly, believes that "Japanese pharmaceuticals are very attractively valued and will lead performance of the sector in 1996."

One pick is Sankyo, whose cholesterol-busting Pravachol was found to reduce mortality in long-term studies and already has posted worldwide annual sales of $1.1 billion. Its price-earnings ratio of 26 is not much higher than that of Western competitors--and much lower than Japan's average p-e of 50.

As drug-stock fever spreads around the world, investors will have every reason to view the lofty prices of drug stocks with caution. But if the pundits prove correct, megamergers and new products should keep the sector sizzling for some time.