Learning From The Drug Debacle

The pharmaceutical industry has over the decades developed an almost unending crop of drugs that has helped to contain disease and improve global health. However, every now and again things can go wrong, and when it does, some investors obviously run for cover.

The recent calamity surrounding Vioxx is one example of what can go awry in the pharmaceutical industry. US drug company Merck (NUSE: MRK) was forced to withdraw this painkiller after in-house studies showed that patients could be at greater risk of suffering heart attacks.

The news has wiped almost 40% or $40b off the value of Merck on concerns that the company could face a swathe of damaging lawsuits. However, US Fool writer Mathew Emmert reckons Merck could afford to pay out as much as $25b in claims over the long-term and still live to tell the tale.

In truth, all drugs have risks, and even the widely-available aspirin has side effects. Furthermore, despite stringent clinical trials, the risks of some new drugs may not become evident for many years after launch.

Consequently, drug companies continually try to improve on existing medicines, which provide welcome alternatives for patients. GlaxoSmithKline (LSE: GSK) for instance reckons its experimental painkiller could be "huge" despite Merck's setback.

Drug companies are also striving to develop new medicines to treat unmet needs. These efforts have been rewarded by a rapid growth in global sales that is in now excess of £250b.

In recent years, drug companies have tended to focus on well-understood ailments, that include gastrointestinal problems, hypertension, pain management. But now that these disorders are well addressed, drug developers are targeting more tricky areas such as obesity, cancer and diseases of the elderly.

However, the biological causes of many of these ailments are still not clearly defined, which is partly behind the recent lull in new medicines. That said GSK believes its bulging pipeline of 22 drugs could each generate eventual sales of $1b a year or more.

Nevertheless, investing in a single drug company carries certain risks, though in my view the long-term hazards with companies such as GlaxoSmithKline and AstraZeneca (LSE: AZN) are slight. This is despite short-term hiccups that saw, for instance AstraZeneca tumble 10% last week after drug regulators in Europe and America raised safety concerns over its anti-cholesterol treatment Crestor. At 1,131p, GSK is valued at 14 times 2005 profits, which is not expensive. AstraZeneca, at 2,130p is slightly more expensive at 16 times earnings.

Investors keen on exposure to the growing drug sector could always consider Finsbury Worldwide Pharmaceutical Trust (LSE: FWP) though. The trust is heavily weighted towards American drug companies and also provides exposure to the more risky biotechnology sector. But whilst a wide portfolio of companies will not reduce sector risk it will lessen company-specific risk.

David owns shares in GlaxoSmithKline.