3 risks of investing in drug stocks

Investors often comment that we sometimes differ with the mainstream view on which stocks make good investments. That’s especially true with drug stocks.

The general view on these stocks seems to be that they are can’t-miss investments because the baby boomers are reaching an age when they will need drugs for a number of medical conditions, and are willing to pay for them.

Look beyond rising demand from boomers when investing in drug stocks

We agree that the aging of the boomers will create demand for drugs. But there are several drawbacks to drug companies that you should keep in mind if you are thinking of investing in them. Here are three major hurdles most drug stocks face:

1. High research and regulatory costs: Drug firms need to spend heavily to create new drugs, and spend even more to gain regulatory approval. Even then, they only get to profit for a limited time before patents run out and generic products appear. Then too, their research spending may lead to dead ends, rather than new drugs that fill a need and can overcome the regulatory hurdles.

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2. Aggressive competition: Drug stocks must deal with increasing litigation and aggressive competition from generics as drugs come off patent. For example, U.S. drugmaker Warner Chilcott (symbol WCRX on Nasdaq) recently filed a lawsuit to stop another drug firm, Lupin Ltd., from making generic versions of its Femcon and Loestrin birth-control pills. Lupin claims that these drugs’ patents are invalid.

3. No brand loyalty: Demand for effective drugs can evaporate overnight, long before the patent expires, if more effective drugs come along. Unlike many other manufacturers, drug stocks don’t benefit from brand loyalty.

However, if you want to invest in drug stocks, we think you should focus on those that have high cash holdings and a number of drugs in the pipeline. All the better if they have access to fast-growing markets, like China, India and Latin America.

Look to medical-supply firms for lower risk gains

Instead of drug companies, consider medical-equipment suppliers. Demand for medical equipment tends to grow, or at least hold steady, regardless of swings in the overall economy. Many of these firms also get recurring revenue, mainly from long-time customers. They also face little competition from generic products, and stand to gain from the aging of the boomers.

Beckman Coulter (symbol BEC on New York) is one example of such a stock. We cover Beckman in our Wall Street Stock Forecaster newsletter.

Beckman makes lab equipment that doctors and researchers use to detect substances in bodily fluids. Beckman gets 90% of its sales from hospitals and clinics. Research labs account for the remaining 10%.

Like drugs, demand for Beckman’s tests should continue to rise as the population ages. Moreover, demand for both drugs and medical equipment is expected to rise as the new U.S. health-care system (nicknamed “Obamacare”) extends coverage to over 32 million Americans who are currently uninsured. That could put Beckman in an ideal position to profit as the major parts of the new system are put in place.

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