The pharmaceutical sector plays a vital part in maintaining the health and well-being of the global populace by developing and marketing lifesaving drugs and medical devices. The global industry is dominated by US and European multinationals. As these companies are a major sector of the economy, they can also have a significant impact on one's financial health by providing solid returns over the long-term. For instance, in the six-year period ending March 6, 2015, the S&P 500 Pharmaceutical index of 14 stocks generated returns of 22% annually. But risks always accompany rewards, so let's see how these stack up for the pharma sector.

Risks

Regulatory risk: The pharmaceutical sector is subject to a great deal of regulatory risk, primarily centered on the drug approval process by the US Food and Drug Administration (FDA), and the reimbursement process for increasingly expensive medications. The rejection of a drug candidate by the FDA can knock a substantial chunk off the market value of a pharmaceutical company, although the deep and diverse pipeline of the pharma giants ensures that the fallout is usually limited (as opposed to a small biotech with only a couple of drug candidates, which can be decimated by a FDA rejection). Similarly, the uncertainties caused by the Affordable Care Act (better known as "Obamacare") doused investors' appetite for pharma stocks for months in 2009 and 2010.

Binary outcomes for drug candidates: The pharma sector is unique in that its product candidates have binary outcomes. A drug candidate that makes it through clinical trials and is commercialized could generate hundreds of millions in revenues and profits over its lifetime; a blockbuster drug could generate billions. The flip side is that the value of a dud drug candidate is essentially zero, which can be a big setback as pharma companies have to spend a great deal to advance their drug candidates through clinical trials. One study estimates it costs a whopping $2.6 billion to develop a new drug and win FDA approval. The vast majority of drug candidates do not make it through the rigorous FDA approval process, so pharma companies constantly have to strike a balance between backing potential winners and winnowing the losers in their stable of drug candidates.

Generic competition: Even after a new drug is approved by the FDA, pharmaceutical companies only have a limited number of years of patent protection and marketing exclusivity. The term "patent cliff" has become almost synonymous with the pharma industry in recent years, given the number of blockbuster drugs that have seen their patents expire, paving the way for competition from manufacturers of similar generic drugs. In 2012, for example, more than $35 billion in annual sales was at risk from pharmaceutical patent expiration, with nine blockbuster drugs accounting for more than three-fourths of that amount. Pharma companies have to contend with a precipitous decline in revenues once a drug goes off patent and is faced with competition from a generic substitute that is available for a fraction of the price.  

Rewards

Stable cash flows: Pharmaceutical companies have stable cash flows because of the nature of their business. It is next to impossible for an individual to forego spending on prescription medication, no matter how cash-strapped he or she is, especially if the medication is required to treat a serious condition. Since spending on medication and health care is non-discretionary in nature, pharma companies have the luxury of cash flows that are typically stable from one year to the next.

Solid balance sheets: Because they generate stable cash flows over decades, most pharma companies have solid balance sheets, with little debt and plenty of cash in hand. This balance sheet solidity enables them to go out and acquire smaller biotechnology and pharmaceutical companies (and occasionally, large ones) that have a pipeline of promising drug candidates, in order to offset the loss of revenue from patent expirations on blockbuster drugs.

Pricing:  Pharma companies also have unprecedented pricing power, even though there has been a backlash from health insurers because of the steep cost of some drugs. Sovaldi from Gilead Sciences, Inc. (GILD), which is used to treat hepatitis C, emerged as a prime target for pricing concerns in 2014, because it cost $1,000 per pill or $84,000 for a 12-weeek course of treatment. But the very fact that the company could charge so much is proof that the sky's the limit when it comes to setting a price for a treatment that can cure a debilitating or fatal illness. Of course, as noted earlier, drugs are expensive partly because of their cost of development and the high failure rate. Pharma companies have great pricing power, and although this may attract criticism in some quarters, their shareholders are unlikely to complain.

Defensive characteristics: The pharma sector is the quintessential defensive sector that is able to withstand the ups and downs of the economic cycle. Most pharma companies also pay a healthy dividend that gives shareholders a regular stream of income. The average yield of the 14 companies on the S&P 500 Pharmaceuticals index was close to 2.3% as of March 12, 2015.

The Bottom Line

Pharmaceutical stocks have risk factors such as regulatory risk, binary outcomes for drug candidates due to the cost of drug development, and generic competition. These risks are offset by pharma stocks' stable cash flows, solid balance sheets, and pricing power. These characteristics, plus a healthy dividend yield, makes pharma stocks a classic defensive sector that is relatively immune to the economic cycle.

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