Bargains Amid the Drug Stock Rubble

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

This dialogue from Ernest Hemingway’s 1926 novel, The Sun Also Rises, could describe drug stocks recently.

Bankruptcy is an exaggeration, but the swift and severe price moves in these stocks is a bit shocking given their long history of incessant and often large price hikes. For years, the playbook for drug companies has been to boost profits via regular price increases.

As a contrarian, I would argue there will be some glittering values on the ground when this storm passes. Yet the regulatory risk of price controls and a shift to permanently lower valuations can’t be ignored. I prefer to limit my dollars at risk by buying call options on drug stocks with less reimbursement exposure or on stocks that benefit from increased research for novel drugs, which are more protected from price cuts.

The straw that broke the camel’s back was Mylan’s 15% price hike on EpiPens last May which followed an earlier 15% increase and was immediately after a competitor’s product was pulled off the market. The political backlash rose to a crescendo and fears of price controls spread like wildfire to the entire drug group. Since the EpiPen news the S&P Pharmaceutical ETF is down 13% and the Nasdaq Biotech Index down 10%.

Short sellers have been circling specialty drug stocks due to egregious price hikes for some time. Way back in 2012 shorts were saw profits over the strategy of Questcor Pharmaceuticals, which raised the price of its drug Acthar from $40 per vial in 2002 to $28,000 per vial in 2012.

Questcor was eventually acquired by Mallinckrodt for a 30% premium to its trading price, leaving most short seller writhing in pain. I reiterate once again, how difficult it is to get the timing right on short sales.

Despite some outrage over the pricing of Questcor’s drug, the patient population was too small to generate sufficient action by insurance companies. They did little to question the pricing of Acthar and continued to reimburse for the drug and for most other drugs with skyrocketing prices.

Only when patients began to feel the weight of monstrous co-pays and deductibles did the balance of power shift. The Kaiser Family Foundation, who tracks insurance data, notes deductibles have risen 50% in the past five years, up to $1,500 for an individual, on average.

While drug companies lived in their parallel universe, increasing prices 10% to 20%, sometimes as often as every six months, consumers were revolting and searching for cheaper options.

Surprisingly to many investors, the PBMs (pharmaceutical benefit managers) and drug distributors have been the biggest benefactors of price increases. While drug companies scramble to remain on formulary lists by offering big discounts, the distributors pocketed the difference between the “list” price of the drug and the price at which they acquired it. Despite their huge drops I would avoid the drug distributor stocks, which have earnings tied more closely to price hikes.

Any draconian drop across a wide swath of stocks is likely to leave some bargains in its path. I’ve already issued one call alert for a drug stock in Profit Catalyst Alert and am digging through the rubble for others.

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