3 reasons pharma stocks are still suffering

If any stock group has the winning market formula, it's the pharmaceuticals. So why have drug companies' stocks, which romped since 2011, done so poorly recently?

Drugmakers, especially biotech firms, have ridden so high for so long due to innovations and an aging population -- and neither of those two influences has waned. Over five years through 2015, according to a Boston Consulting Group survey, four of the best-performing large-capitalization stocks were in the pharma industry, with Regeneron Pharmaceuticals (REGN) at the very top.

But this year the health sector is down 4 percent -- the worst showing in the Standard & Poor's 500, tying financials. The trouble actually started last July. Since then, the Nasdaq Biotechnology index has fallen by 34 percent and the broader S&P Pharmaceuticals Select index 38 percent.

By contrast, the S&P 500 itself, after a late-summer swoon and a 10 percent correction this past winter, is almost back to where it was in July. Drugmakers have stayed in the cellar.

"They've been slaughtered," said John E. Maloney, chairman of M&R Capital Management in New York, which invests in health care stocks.

The fate of Regeneron, which is off 33 percent since last summer, is illustrative. This company seems to have everything going for it, but that's not enough.

It produces the blockbuster drug Eylea, which prevents blindness for patients with a type of macular degeneration. Eylea was responsible for half the company's 2015 revenue. And Regeneron recently reported positive results from trials for its new treatment for a vexing skin ailment called atopic dermatitis. The skin drug, dupilumab, is pending final regulatory review and is expected to launch in the third quarter, with projections of up to $4 billion yearly in peak sales.

What's more, revenue has been trending smartly higher, hitting $1.2 billion in this year's first quarter, up more than a third from the year-prior period. Net income doubled, to $166 million.

Like many biotech outfits, Regeneron has an alliance with a larger pharma company, France's Sanofi (SNY). Despite its flagging stock, Morningstar analyst Stefan Quenneville wrote that Regeneron's "increasingly diverse pipeline, strong commercialization partners, and scientific leadership should comfort investors."

Pharma's humbling stems from three factors:

The stocks got too expensive. When enthusiasm for a stock sector pushes share prices skyward, investors often pull back, if only to take profits. In pharma's case, the valuation multiple, which measures how expensive the field is, shows that prices have outstripped earnings far too much.

Regeneron's price-earnings multiple last July was a stratospheric 174. Lately, it has shrunk to 62, which is still high by historical standards. In fairness, larger drugmakers like Merck (MRK), with multiple product lines and huge balance sheets, have lower multiples, although generally they're still above the market average: Merck is at 33.

With the S&P 500's p-e around 22, it suggests that drug stocks likely will fall more in coming months. Pharma "has had a good run, but now it has cooled off," said Michael Cuggino, chief executive of San Francisco-based Pacific Heights Asset Management, which invests in health care stocks.

The overall market's tumbles since mid-summer slammed the pharma sector harder than others. It's telling that while the broader market has recovered, drug shares haven't. Despite scientific advances and favorable demographics, the industry suffers from long lead times to get its products through the regulatory maze and on sale. That often makes it a boom or bust play. Now the sector is in the bust phase.

Prices for actual drugs became overpriced, too. While pharma stocks have suffered, their products have not shown any similar price declines. Huge hikes in the cost of medicine have captured headlines and sparked public outrage, which have translated into pressure on the shares.

The 5,000 percent surge in the list price for a parasite treatment, from Turing Pharmaceuticals, is the most extreme example. A survey by Bloomberg found that since the end of 2014, prices had more than doubled for 60 drugs and had quadrupled for 20 others. For many other medicines, even those whose patents were soon to expire, prices rose 10 percent or more.

In April, the U.S. producer price index indicated that prescription drugs soared 8.5 percent from 12 months before, the fastest increase in 17 years. Even generic drugs -- that is, those whose patent protection is gone, which makes them cost less than when they were under patent -- show price increases.

To be sure, hospitals and other large buyers get discounts off the list prices for drugs. Plus, Medicare and private insurers impose ceilings on what they'll reimburse in a bid to hold down drug prices. Nevertheless, the upward spiral shows little sign of abating.

Pharma has suffered political backlash. The price spikes have led to congressional hearings and crackdowns on industry figures. Valeant Pharmaceuticals (VRX) found itself the target of a federal investigation after it jacked up the prices of two heart drugs more than threefold. The probe is related to Valeant's finances and distribution methods. The company, which switched chief executives after the controversy emerged, has denied any wrongdoing.

Turing's former chief executive, Martin Shkreli, earned widespread condemnation for refusing to answer questions at a hearing before a House of Representatives panel -- and smirking at the cameras. He then sent out a Twitter post that further inflamed his critics, especially on Capitol Hill: "Hard to accept that these imbeciles represent the people in our government."

Later, Shkreli got hit with a federal indictment on charges of securities fraud, related to his time on Wall Street, not the pharma industry.

In addition, the industry also has attracted criticism as the biggest player in the tax-minimizing "inversion" game. That's where an American company merges with a smaller outfit in a country with lower taxes and technically shifts its location there. The U.S. Justice Department has stepped in to curb the practice, which squelched such a deal between New York-based giant Pfizer (PFE) and Ireland's smaller Allergan (AGN).

All this turbulence argues that pharma stock prices aren't heading up in any meaningful way, any time soon.