When considering the performance of the pharmaceuticals sector, an investor is almost always challenged with the question of definitions. Simply put, what exactly is a pharmaceutical company and where are the lines between "biotech," "specialty pharmaceutical," "generic," and regular ol' pharmaceutical companies? (For related reading, see Evaluating Pharmaceutical Companies.)
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Leaving aside the issue of nomenclature, and acknowledging that there is some subjectivity involved in who is included or left out, this was actually a fairly strong year for the sector. True, fewer people are seeing the doctor, high unemployment means fewer people on insurance rolls, and overall health care spending has not been very strong. Nevertheless, the market has warmed to these stocks, as the iShares Dow Jones U.S. Pharmaceuticals ETF (ARCA:IHE) has handily beaten the market this year and risen by a solid mid-teens percentage.

Relatively Little Red
One of the first things that jumps about this sector's 2011 performance is the relatively small number of losers. Forest Labs (NYSE:FRX) and Novartis (NYSE:NVS) both seem likely to end the year in the red, with Forest Labs really suffering from Wall Street's doubts regarding the company's ability to replace soon-to-be-lost sales from patent expirations. Warner Chilcott (Nasdaq:WCRX) has done even worse, though, with the stock returning a loss of more than 30%, as the company lost exclusivity on osteoporosis drug Actonel, saw a dermatology drug distribution agreement end, and faced higher than expected costs in converting a manufacturing plant into a distribution center.

Some Big Winners
On the green side of the fence, there were some surprisingly successful stories in the drug sector this year. Valeant Pharmaceuticals (NYSE:VRX) has been aggressive in restructuring its operations and the stock has returned nearly 60% so far this year. Even the goliaths have gotten into the act; Bristol-Myers Squibb (NYSE:BMY) and GlaxoSmithKline (NYSE:GSK) have risen over 30 and 20% respectively, this year.

Bristol-Myers not only has an encouraging pipeline, but the company has delivered better-than-expected sales of some key new drugs, while also paying an attractive dividend. Glaxo, meanwhile, has coupled good emerging markets and vaccine exposure, and has perhaps benefited from being too badly beaten-down in times past.

Are the Gain Already Bagged?
The downside to this strong 2011 performance may be that it has robbed some of the momentum from 2012. Many stocks have already traded up on the expected benefits of new product approvals and further cost-cutting, leaving many companies hard pressed to deliver more red meat to an always growth-hungry market.

The Bottom Line
Looking into the next year, then, investors may be better served shopping in the scratch-and-dent aisles. Forest Labs, for instance, has a long history of defying the skeptics and finding ways of rebuilding its revenue. Novartis has a well-integrated suite of businesses and an undemanding valuation, while Merck (NYSE:MRK) may be undervalued for its earnings quality. If there is a 2011 winner to bet on for 2012, it may well be Pfizer (NYSE:PFE). Though this stock has climbed nicely already (up more than 20% for 2011), the stock still looks undervalued for its long-term potential. (For a quick introduction to biotechnology's place in the market, read A Primer On The Biotech Sector.)

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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