Drugmakers: Not So Recession-Proof?

Barring the mother of all rallies on Monday, it looks like the first half of this year will prove unfriendly for the biotech and pharmaceutical sectors.

Unsurprisingly, considering the deluge of negative economic, financial, and industry-specific news over the past several months, the major biotech and pharmaceutical indices are all down for the year in this rough stock market environment.

But it may be surprising just how different the biotech and pharmaceutical sector indices have performed versus one another and the broader market indices. With shares of pharma giants like Merck and Schering-Plough (NASDAQ:SGP) getting kicked down 36% and 28% in the first half of the year because of Vytorin and Zetia issues, and Pfizer (NYSE:PFE) falling precipitously over generic competition concerns, the American Stock Exchange Pharmaceuticals Index has declined nearly 15% in the first half of 2008.

The American Stock Exchange Biotech Index and the Nasdaq Biotech Index have also been in the red this year. It's important to understand that the AMEX Biotech Index is heavily weighted toward what are fondly called the "picks and shovels" of the biotech sector, like Invitrogen (NASDAQ:IVGN) and Illumina (NASDAQ:ILMN). The Nasdaq Biotech Index, while excluding biopharmaceuticals behemoth Genentech (NYSE:DNA), covers a much broader swath of young drug developers.

While the two biotech indices differ in these significant ways, both are down much less for the year than the AMEX pharma index, thanks to a combination of excellent clinical study results for some biotech giants like Gilead Sciences (NASDAQ:GILD) and Vertex Pharmaceuticals, and positive dealmaking news like Takeda's acquisition of Millennium Pharmaceuticals.

*Rounded

While investors surely don't put their hard-earned investing dollars into pharmaceutical and biotech stocks in hopes of losing money, biotech does get some credit for outperforming the broader stock market indices in the first half of the year.

Fortunately for some investors, a falling stock price can create Inside Value-type investment opportunities. While not every large-cap pharma looks like a steal at today's prices, shares of some big diversified drugmakers, like Eli Lilly and GlaxoSmithKline (NYSE:GSK), now sport dividend yields greater than 4%. Also, their lower share prices have wrung some of the downside risk out of their shares.

While there's no way to definitively prove it, I believe that (despite perceptions) most of the declines in drugmakers' shares in the first half of the year aren't largely due to factors like the economy or oil prices. Instead, I think they owe to internal factors at some of these companies. In the past, for instance, large-cap pharma has sometimes significantly outperformed the broader stock market in recessions.

In the long term, performance in the biotech and pharmaceutical sector will ultimately be determined by how these companies' pipeline drugs fare in the clinic, how well these drug candidates are received at regulatory agencies like the FDA, and whether payers choose to pony up for the compounds. Investors willing to pick individual stocks should be able to beat the indexes by picking businesses with the best pipelines. Invest accordingly.