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Do Generic-Drug Makers Belong in Your Portfolio?

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Last week, I tackled the topic of whether orphan drug developers -- which gear their research toward rare and unmet diseases -- deserved a place in your portfolio. Today we're going to turn out attention to the vultures of the pharmaceutical world, generic-drug makers, and see if they too deserve your hard-earned investment dollars.

According to a report by the British Medical Journal in 2011, 70% of all prescriptions in the United States were for generic drugs. In Great Britain, it was an even higher 83%. Clearly, someone has to be making money off these drugs, but what are the pros and cons of investing in generics? Let me walk you through a few:

Why investing in generic drug makers is a smart move:

  • A seemingly endless pipeline: Branded-drug makers only have finite periods of time when they can market their drugs before being exposed to generic competition. The patent period for drugs in the U.S. is 20 years and begins while a drug is in clinical trials. Given the lengthy time needed to test a drug's efficacy and safety in trials, branded drugs rarely get more than 15 years of marketing exclusivity, providing a constant pipeline of potential generic drugs to produce.
  • Generic drugs are cheaper: Cheaper does indeed mean lower margins, but it also means a higher propensity to be prescribed by physicians and a greater chance that individuals will properly follow the dosage requirements and complete a treatment. Generic producer Mylan (NASDAQ: MYL  ) is a great example. Its gross margin has come in consistently between 40% and 42% since 2008 (roughly half the rate of big brand-name pharmaceutical companies), but it's seen its product portfolio and prescription orders expand rapidly.
  • Costs are minimal: Generic-drug makers are only required to create a bioequivalent product that produces 80% to 125% of the effectiveness of the branded drug in order to be approved. Given this wide range and the absence of needing to conduct clinical trials, generic-drug makers are able to focus almost all of their efforts of production, keeping generic drug costs significantly lower than branded-drug costs.

But before you get too excited, consider these key negatives:

  • Generics discourage innovation: Just as generic-drug makers are helping make existing drugs slightly more affordable for the general public, their presence also discourages research and innovation. Considering that the typical drug can cost $1 billion in research and development to bring to market, the possibility of turning a profit on that drug before its exclusivity period expires is no longer certain.
  • Lots of competition: When Pfizer's (NYSE: PFE  ) Lipitor -- previously the best-selling drug in the world -- went off patent, it wasn't as if one company was waiting in the wings to lay claim to producing a generic version. There are, in fact, six other generic-drug makers producing versions of the drug worldwide, in addition to Pfizer's own heavily discounted branded version.  
  • High potential for lawsuits and petitions: Branded-drug makers will fight tooth-and-nail to retain exclusivity on their drugs, which often results in a molehill of legal battles for generic-drug makers. The most notable (and a very long ongoing) case I can recall was between ViroPharma -- which produced Vancocin, a gastrointestinal infection-fighting drug -- and Watson Pharmaceuticals (NYSE: AGN  ) and Akorn (NASDAQ: AKRX  ) . ViroPharma used a citizens petition with 18 separate supplements over the course of nearly five years to block generic competitors. ViroPharma eventually lost its bid last year to keep generic competitors from entering the market.
  • Bioequivalent doesn't equal equivalent: There are a lot of instances where generic drug are perfectly suitable substitutes for branded drugs. Conversely, there are also certain diseases that require very specific dosages and absorption times, which may not be exactly the same for generic versions of a drug. Generics are free to use different inert ingredients, which can change absorption times, reduce the effectiveness of the drug, and even increase side effects.

The $64,000 question: Do generics belong in your portfolio?
In spite of a laundry list of pros and cons, I think the proof is in the British Medical Journal's pudding that 70% of all medication being prescribed is generic in nature. To me, this signifies that big bucks are being spent on generics and overall public opinion of generics tends to be positive, primarily because of their low-cost aspect. Investors should come to expect lower margins from generic producers, but can also expect more stable cash flow than you'll often find in branded pharmaceutical names that frequently have drugs falling off patent.

Now you're probably wondering which company, or companies, might offer investors the greatest return for their investment. There are two, in particular, that I fancy: Akorn and Teva Pharmaceutical (NYSE: TEVA  ) .

One aspect that makes both Akorn and Teva attractive is that they deal in both branded and generic drugs. Being a hybrid drug producer allows Akorn and Teva to boast higher margins than most generic drug producers, yet stay considerably more consistent with their cash flow growth than most branded pharmaceutical companies.

For those with a greater penchant for risk, Akorn would be the generic-drug maker I'd suggest looking into. Akorn's recent guidance projected that higher R&D expenses would cut into its gross margins by 200 to 400 basis points from 2012 levels, but forecast launching a mix of 39 branded and generic drugs between 2013 and 2015 with a market value around $3 billion. Akorn isn't cheap at 24 times the midpoint of its guidance, but it could offer the most rapid growth rate of generic drug makers between now and 2015. 

On the safer side, Teva offers investors one of the most impervious pipelines in the business. Teva shares could take a hit when its $3 billion per year multiple sclerosis drug, Copaxone, goes off patent in September 2015, but it has a portfolio of more than 1,400 molecules ready to take its place. With a revenue mix that entails getting 55% of sales from generics, 35% from branded sales, and 10% from other ventures, Teva is a cash flow powerhouse. It's no wonder that Teva's quarterly payout (which may I add isn't consistent quarter to quarter) is up around 1,300% in just the past decade. At just seven times forward earnings, Teva is a bargain for any generic-focused investor.

Have a favorite generic producer that I've failed to mention? Share it with the community in the comments section below.

While you can certainly make huge gains in biotech and pharmaceutical stocks, the best investing approach is to choose great companies and stick with them for the long term. In our free report "3 Stocks That Will Help You Retire Rich," we name stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Read/Post Comments (1) | Recommend This Article (4)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 23, 2013, at 7:46 PM, prginww wrote:

    Great picks! I've held onto Akorn for about 3 years now and recently picked up Teva. The issue this Akorn is the amount of short interest, though it hasn't caused me to change my opinion of the company. Rajat Rai and John N. Kapoor have akorn heading in the right direction.

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