The OECD released a new study on trends in pharmaceutical spending in the developed economies, telling us what we already knew: expenditures on drugs have taken wing.

The extent of the spending increase is striking nonetheless. From 1998 through 2003, consumer purchases of pharmaceuticals advanced by an average of 32% a year in real (inflation-adjusted) terms across the OECD countries, which includes the United States, Western Europe, Japan and generally the developed markets around the world. In fact, drug spending’s rise has outpaced total health expenditures over the past five years in most OECD countries. In the U.S., for instance, spending on drugs grew more than twice as fast as total health expenditure.
The combination of demographic trends (the aging of populations in developed nations) and innovative drug research and development has converged to deliver a golden age to the business of selling drugs.
Or so one would think. A more bullish backdrop than the one painted by the OECD report could hardly be imagined for an industry. But to judge by the big-cap healthcare stocks in the S&P 500, the investment outlook appears somewhat more nuanced. Indeed, one could argue that investing in the big-cap drug names is something less than a sure bet at the moment The drug industry, simply put, has a few health problems of its own.
Some of troubles can be attributed to wonder drugs gone bad. Paying for the cleanup is proving to be expensive. Eli Lilly, for example, agreed last week to pay $690 million to settle legal claims that the company inadequately warned that taking its anti-psychotic drug Zyprexa could lead to diabetes. How big a bite is $690 million for Lilly? Roughly 38% of 2004 net income.
Lilly is far from the only big-cap drug company fending off lawsuits these day. Merck and Pfizer have their own legal battles tied to pain killers. Is it taking a toll on earnings? It sure as heck ain’t helping.
Whatever the reason, something’s certainly putting a drag on earnings momentum in a sector that not that long ago was touted as among the best-positioned corners of corporate America for cashing in on the aging of the Baby Boomers. But so far, the results look middling at best.
Consider that the S&P healthcare sector’s operating earnings rose by 15.5% in the two years through the end of 2004, according to data from Standard & Poor’s. Impressive? Depends on the benchmark. For example, the drug industry’s rate of growth is far below the 47% rise in S&P 500’s earnings advance over that period. In fact, on a percentage basis, healthcare’s earnings advance was near the bottom among the ten sectors that comprise the S&P 500: only three other sectors (consumer staples, telecom, and utilities) posted lesser rates of earnings growth over the two years.
Looking at long-run performance of the S&P’s healthcare stocks depicts more lethargy. Over the last three years through the end of last month, for example, the S&P 500 Healthcare Index’s 2.5% annualized total return has trailed the S&P 500’s 5.6%.
On the other hand, year-to-date comparisons paint a different picture. Indeed, the S&P Healthcare Index is up 3.9% in 2005 through June 9, crushing the S&P 500’s small total-return loss over that stretch. Is health’s rise this year simply a dead-cat bounce, or is something more fundamental afoot?
One ETF analyst who follows the S&P 500’s sectors suggests caution when it comes to drugs. He writes recently that there are still clouds on the horizon for the big drug stocks. First-quarter numbers reveal that the fundamentals for the S&P healthcare sector “continue to deteriorate,” observes Michael Krause of AltaVista Independent Research in New York. In particular, he notes that return on invested capital for pharmaceuticals fell for a fifth year in a row to 12.6% annualized, down from 18.8% in 2000.
If investors are expecting earnings to come roaring back in the big-cap healthcare stocks, the optimism isn’t yet reflected in the 2005 estimates posted by Standard & Poor’s for the sector. For all of 2005, healthcare’s operating earnings (based on bottom-up estimates as of May 31) are expected to advance 8.4% over 2004. That’s below the predicted 10.9% rise for the S&P 500 overall and far below the comparable forecasts for the more impressive double-digit gains expected in five other sectors, including the soaring 27% earnings gain envisaged for materials stocks this year.
But Mr. Market doesn’t necessarily agree. In fact, he’s expecting something on the order of the opposite from what the predicted operating earnings for 2005 suggest. Consider that while the price for the Materials Select Spider Trust ETF (Amex: XLB) has lost more than 6% this year through June 9, the Healthcare ETF (Amex: XLV) has climbed 3.3%. So much for clear and concise connections between earnings projections and equity performance.
The market may be more or less efficient, but the associated messages dispensed from the belly of Mr. Market’s beast can still be cryptic.