Drugs fall from dizzy heights, but investors should stand by science

Despite patent problems, there are opportunities in healthcare stocks, writes Simon Hildrey

Three years ago, pharmaceutical companies appeared to offer healthy solutions for investors. But ever since the technology bubble burst, healthcare has struggled to produce anything approaching vigorous returns.

Three years ago, pharmaceutical companies appeared to offer healthy solutions for investors. But ever since the technology bubble burst, healthcare has struggled to produce anything approaching vigorous returns.

In 2000, the sector was a top performer, with one of the biggest drugs companies, GlaxoSmithKline, comprising more than 10 per cent of the FTSE 100. In a society with an ageing population, requiring more medical treatment – particularly drugs – this growth seemed likely to continue. What appeared to be an endless supply of medicines was coming on to the market, and pharmaceutical companies looked certain to benefit.

But the sector fell in value during 2001 and 2002, the first time in the past two decades that it has declined in consecutive years. And in the past 12 months, according to the ratings agency Standard & Poor's, the sector has fallen again, this time by 36 per cent.

In the past year, among healthcare funds, First State Global Health & Biotechnology has fallen by 34.09 per cent, Framlington Biotechnology by 49.6 per cent, Framlington Health by 42.68 per cent, M&G Global Health Care by 30.83 per cent and Schroder Medical Discovery by 30.78 per cent. This compares with declines of 25.03 per cent in the FTSE All Share and 29.21 per cent in the S&P 500.

Pharmaceutical stocks have been hit by the expiry of an increasing number of patents, by successful court challenges to other patents by generic companies, and by a slowdown in the development of new drugs. Pharmaceutical companies are also coming under pressure to offer drugs at cheaper prices to the developing world.

Patents are vital to the drugs firms. They last 17 years but start from when they are registered – usually when the drug is first developed in the laboratory – not from when they come to market. This means pharmaceutical groups have between 10 and 12 years to make money from their exclusivity.

It has been estimated that in 2002, drugs with sales totalling $8.5bn (£5.4bn) saw their patents expire. This figure is expected to rise to $18.4bn in 2003, then fall to $15.2bn in 2004 and $10.5bn in 2005. It expected to rise again in 2006 when one drug alone, Merck's cholesterol drug Zocor, worth $5bn, will come to the end of its patent.

This situation has been exacerbated by the increasingly aggressive challenges being issued in court by generic companies. It has been estimated that 75 per cent of these challenges are successful and that 11 blockbuster drugs with annual sales of $15bn currently face patent attacks. GlaxoSmithKline, for example, has two patents being challenged, according to Joe Anderson, head of global health and biotechnology at First State Investments.

Successful challenges to patents have had a dramatic effect on the sales of big pharmaceutical companies and have increased the risk of investing in the sector. Caspar Rock, part of the healthcare team at Framlington, says sales of branded drugs can decline 90 per cent in the first 90 days after the end of a patent.

Mr Rock adds that patients in the US are being encouraged to use cheaper generic drugs rather than branded ones by the four big pharmacy benefit managers, who manage prescription drug benefit programmes for employers, unions and health insurers. This is affecting margins and sales of branded drugs.

But this gloomy picture does not mean investors should ignore the healthcare sector. Of course, as Robert Burdett, co-head of Credit Suisse Asset Management's multi-manager service, says, many will already have healthcare investments without even knowing it, because mainstream funds have significant exposures to the sector. Healthcare stocks make up 14.5 per cent of the S&P 500 index, 10.5 per cent of the FTSE All Share and 10 per cent of Europe excluding the UK.

Mr Anderson at First State Investments argues that there is still strong demand for the sector. "The population is ageing, and as we get older we spend more money on healthcare," he says. "It has been estimated that 80 per cent of what we spend on healthcare in our lifetime is spent in the last year of our life."

Healthcare comprises more than simply big pharmaceutical companies. Samuel Isaly, manager of the Close Finsbury Pharmaceutical fund, points to three sub-sectors: biotechnology, medical devices and health services.

"Biotechnology stocks are higher-risk investments than big pharmaceutical companies," he says, "but they offer the potential of higher returns. They are not as vulnerable to patent challenges because protein is not as easy to replicate as chemical pills. We have identified 50 biotechnology stocks that are either profitable or will be by 2006."

Biotechnology firms are also offering licensing agreements to pharmaceutical companies to distribute their drugs, so increasing their revenue.

When deciding whether to invest in the sector, investors should analyse the quality of the company's management and cashflow, as well as determining the number of new drugs in the pipeline and the number of patents being challenged. A managed fund is often the simplest way in, and tends to be less risky than investing directly in individual companies.

Disease crisis in developing world

* Aids will kill 46 million people this decade in the 53 worst-affected countries, according to the United Nations Population Division. This figure is forecast to rise to 278 million by 2050.

* HIV/Aids infection rates are greater than 30 per cent in a number of African countries, including Botswana, Lesotho and Zimbabwe.

* Tuberculosis (TB) kills approximately two million people each year. It is estimated that between 2002 and 2020, approximately one billion people will be newly infected, more than 150 million will get sick, and 36 million will die if more is not done to bring the disease under control.

* Malaria is the cause of 300 million acute illnesses and around a million deaths each year. There is increased resistance to existing treatments.

* Twelve infectious diseases account for 20 per cent of the world's global disease burden.

Source: ISIS

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