Even top drug stocks can be riskier than many investors assume, but here’s how to spot the best ones

Top drug stocks hold special appeal for investors: Many assume that as the baby-boom generation moves into retirement, demand for pharmaceuticals will skyrocket. That’s undoubtedly true.

The amount of money the U.S. spends on healthcare could grow to $5.5 trillion by 2025. Some studies project the average growth in health spending will be 6% per year. Rising costs for medical services and products are key drivers of that increase. The rapid aging of the population is another major factor.

However, as we’ve often pointed out, this high potential can lead investors to underestimate the risks in drug stocks. Drug companies often invest tens if not hundreds of millions of dollars to create, test and secure regulatory approval for a single new drug. Even when regulators grant approval for a new drug, the company may be unable to recover its investment before its patent on the drug expires or a better drug hits the market.

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That’s why investors need to be highly selective in choosing their drug stocks. It’s also why Pfizer is the only drug stock we recommend to our clients as a buy. We’ve done so since 2011 and the stock has rewarded our investors with a solid 74% gain, along with a near doubling in Pfizer’s dividend from the $0.80 a share of 2011.

We see Pfizer as engaged in a broad transformation effort to streamline its operations and build on that impressive return for investors:

• Its reorganization promises investors spinoff gains
• The company’s impressive R&D efforts will power its strong drug pipeline
• Its bright future will pay off for investors with more dividend hikes—that’s on top of 5.6% increase coming in March 2020

When looking for top drug stocks you need to be aware of their unique risks

On a more general level, most major pharmaceutical companies, however, are a more speculative investment than most investors realize. They need a continuing flow of successful new products to maintain their earnings. They face increasing litigation and aggressive competition from generics as drugs come off patent. Unlike tech stocks, they have formidable regulatory burdens, and unlike other manufacturing stocks such as, say, auto companies, they do not benefit from customer loyalty.

The aging of the boomers will create demand for drugs, and that some drug firms will benefit from treating new diseases. But there are several drawbacks to drug companies that you should keep in mind if you are thinking of investing in them.

In particular, drug firms need to spend heavily to create new drugs, and spend even more to gain regulatory approval. Even then, they only get to profit for a limited time before patents run out and generic products appear. Then, too, their research spending may lead to dead-ends, rather than new drugs that fill a need and can overcome the regulatory hurdles.

In addition, demand for effective drugs can evaporate overnight, long before the patent expires, if more effective drugs come along.

As well as top drug stocks, don’t overlook medical equipment suppliers

If you want to invest in drug stocks as part of a Successful Investor portfolio, we think you should focus on those that have high cash holdings, an established portfolio of drugs without near-term generic competition and a number of other up-and-coming drugs in the pipeline. All the better if they have access to fast-growing markets such as China, India and Latin America.

Meantime, demand for medical equipment tends to grow, or at least hold steady, regardless of swings in the overall economy. Many of these firms also get recurring revenue, mainly from long-time customers. They also face little competition from generic products, and stand to gain from the continued aging of baby boomers.

While pure drug stocks can be risky, other fields of medicine and health care can offer a number of other stocks we recommend that meet our Successful Investor criteria. For example, we like health care stocks with recurring revenue, which can come from the sale of lab supplies, maintenance on equipment or other sources. We feel that these revenue streams can be quite secure.

Use our three-part Successful Investor approach to get long-lasting portfolio benefits—including investments in the top drug stocks

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

How much impact do you think the political environment has on the success or failure of drug stocks?

How do you think regulations impact the price of pharmaceutical stocks?