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With investors preparing for a downturn, defensive stocks are shooting through the roof. But there is an exception: pharmaceuticals. The sector remains mired by structural problems, mainly blockbuster drugs that will go off patent in the next few years, falling research & development productivity, and pricing pressure, especially in the US. The question for investors is whether they can pick out the coming success stories amid the general malaise.

Five years ago, the answer would have been Roche. The Swiss company led a move toward specialisation, with its early investment in Genentech, the US biotech concern, and its focus on products aimed at small groups of patients with life-threatening diseases. The result was a stable of high-value, small-volume drugs that are harder to copy, less vulnerable to product liability lawsuits and resistant to pricing pressure. Drugs due to come off patent between 2008 and 2012 accounted for just 11 per cent of the company’s 2007 drug sales, estimates Lehman Brothers. But Roche and its recent imitator Bristol-Myers Squib are relatively expensive now, trading at 15 times 2008 forecast earnings.

The cheap pharma stocks are the ugly ones: companies heavily invested in mass market drugs. Wary of expensive biotechnology acquisitions, they have opted instead for cost-cutting (Pfizer) or stuck with diversification (Johnson & Johnson). They hope bottom-line growth and stable revenue from other sources will comfort investors during the drug development cycle.

The idea of buying into these companies is enough to give one cold sweats: they have underperformed badly and have obvious problems. Big players such as Pfizer, AstraZeneca and GlaxoSmithKline are at risk of losing about one third of their pharma sales to generics by 2012, says Lehman. But these companies have been de-rated to forward earnings multiples of between 10 and 13 times. Big pharma is not exactly pretty. But in an environment where other sectors are facing cyclical pressures, that leaves room for pleasant surprises.

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