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By Jeremy Glaser | 07-05-2011 11:16 AM

Pharma Stocks Still a Bargain

Despite the strong performance of health-care stocks in the second quarter, there are still plenty of good buying opportunities in the sector, according to Morningstar's Damien Conover.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The health-care sector was the best performer in the second quarter of 2011 after a few quarters of underperformance.

Here today is Damien Conover, the associate director of Morningstar's health-care team to talk a little bit about why pharma stocks did so well during the last three months and what he expects in the future?

Damien, thanks for joining me today.

Damien Conover: Thanks for having me, Jeremy.

Glaser: So let's take a look back first. What drove that outperformance, in these health-care names and in these pharma names in the second quarter?

Conover: Yeah, I think it's an important question. Like you mentioned, it was very strong rally for health care overall and Big Pharma in particular. I think sentiment is shifting quite a bit; I think there's a couple things going on here.

The macro trends within health care are improving, meaning we're seeing hospital spending a little bit more and we're seeing more people engaging with health care a lot more. So we're seeing the overall demand kind of uptick a little bit after we kind of came out of a recessionary environment.

Although health care is traditionally pretty resistant to the economy, this time the pullback was so severe that a lot of demand kind of came off. We're seeing that demand return, and we're seeing a lot of stabilization there. I think sentiment is really kind of coming around to seeing these names as particularly low valuations and really driving some buying in this area.

Glaser: The world hasn't blown up yet, as lot of people thought in the health-care space, as there was kind of almost a relief rally in some respect.

Conover: Right, absolutely, it's almost a relief rally. We still think the valuations are pretty favorable, so we think there's a lot of interesting investment opportunities within health care. Also from a macro standpoint as there is more uncertainty over the overall economy, I think more and more investors are going to want to get into health care because of their defensive nature.

Now granted it was put to the test in the last pullback, but there still is a strong element of being resilient to a poor economy. So as that uncertainty over the overall economy increases, I think more interest in health care continues to go along.

Glaser: Let's look forward then. I know there's been a lot of concerns about the patent cliff, that a lot of important drugs are coming off patent for many big firms. There's been worry about research and development efficiency and some rising costs. Do you think Big Pharma will be able to tackle these problems? What do you expect for the rest of the year?

Conover: Yeah, it's a great question. When I talk with folks, you know, the big questions are: "What about the patent cliff? What's going to happen here?" But now, as I've been talking to folks more recently, it's like: "What's next?" People are starting to realize, "Hey, we are in the patent cliff, and it's not that bad." Firms are cutting costs, and they are selling more drugs in emerging markets where patents aren't as important.

So, you are seeing these different trends mitigate this huge patent cliff, and I think the outlook is becoming more and more favorable. However, the pipelines still haven't improved probably to the degree they need to, to really return these firms to very strong growth, but they are getting better. And I think as the next year comes around, the pipelines will continue to get better, and we'll see some pretty important new drug launches which we expect will really have some new blockbusters during the next decade.

Glaser: Mergers and acquisitions are another thing that we've talked about in the past that could be a major factor in the coming years. Do you still think that's the case?

Conover: I think so. I think M&A is going to be a big reason for some growth for these companies going forward. So, instead of developing all the products in-house for Big Pharma, I think there is going to be external development by M&A. So, it's very likely that we are going to see a lot of other Big Pharma firms following Pfizer's footsteps of cutting research and development by 20%.

I don't know if they are going cut it to that degree, but I think they are going to be pulling back on their R&D of internal development and kind of outsourcing that innovation. I think that trend continues. I think it's very likely that we see a lot of biotechnology firms with some innovative new products to be taken out by Big Pharma.

Glaser: You mentioned that you still saw some interesting or some attractive evaluations in the sector. Can you talk about a few names that you think look like good buys right now?

Conover: Yeah. The name we'd highlight the most is Abbott Laboratories. This is a company that we are anticipating 9% bottom-line growth during the next five years. So, each year for the next five years will have 9% growth. That's relative to the industry of about 1%. That 1% is particularly low because we are actually in the patent cliff right now, so the growth is very poor for the rest of the firms.

However, Abbott unlike its peer group doesn't face the massive patent cliff and has a very strong current group of products and a relatively good pipeline. These things we believe really position Abbott for strong upside.

Glaser: Are there any other names that you think could be interesting?

Conover: I think another name that's pretty interesting is Novartis. Novartis is a company that has a very good pipeline. So, if we were to rank all the pipelines in the big pharmaceutical space, Novartis is at the top of the list. I think as this pipeline unfolds, the growth rate for Novartis should improve dramatically.

Glaser: Damien, thanks so much for your thoughts today.

Conover: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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