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By Jeremy Glaser and Damien Conover, CFA | 07-05-2012 01:00 PM

Pharma Looking Defensive Again

Pharmaceutical firms have adapted to their patent cliffs better than investors expected, and solid pricing power and improving pipelines are allowing them to push through macro headwinds.

Jeremy Glaser: For Morningstar I'm Jeremy Glaser. The big pharmaceutical stocks have outperformed the broader market over the last year. I'm here today with Damien Conover,  director of pharmaceutical research, to see if there is still value left in these stocks and if so where it is.

Damien, thanks for joining me.

Damien Conover: Thanks for having me, Jeremy.

Glaser: As a sector we used to think of pharmaceutical stocks as being pretty cheap. Quarter-after-quarter we always looked at them as one of the least highly valued sectors, but that really has turned around recently. What's driven that outperformance from these stocks, and do you see any value there?

Conover: I think that's a really good question, Jeremy. When we look at the strength of the pharmaceutical stocks over the last year, a lot of that has been driven by the pharmaceutical stocks moving into their major patent cliff and adapting to that patent cliff better than what I think investors were anticipating. They are cutting costs, they are getting their pipelines back on track, and they are getting to be much better-positioned than I think most investors had feared would be the case moving into this patent cliff. Going forward we anticipate that these stocks are still undervalued, and as a group we see the pharmaceutical stocks as about 10% undervalued. And some of those drivers that I mentioned, such as cost-cutting and better pipelines, we expect will really move the group higher

Glaser: But certainly economic growth has to be a concern. Certainly, we think of these stocks historically as being somewhat defensive, but during the last downturn they sold off pretty sharply. Would you expect that this sector would hold up better-than-average if we were to enter another sustained global slowdown?

Conover: I think so. I think investors are starting to look to this group again as a defensive space. If we look back at the past recession, this group traded down with the broad market, but I think that also coincided with these firms really at the beginning of the patent cliff. So there were lot of stock-specific reasons for these names to trade down, at the same time the market was pulling back. As we move into potentially another recession, and if we do move into another recession, I think these stocks will hold up better than in the last downturn, and that's largely to do with the fact that the patent cliff is getting behind these names and pipelines are starting to improve.

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