The Street | Which Drug Stocks May Get a Lift Next Year

Compromise on Capitol Hill, cheap valuations and consolidation among drug companies will propel health-care stocks in 2011, says Michael Gregory, manager of the Highland Long/Short Healthcare Fund (HHCAX).

The mutual fund is up 10% this year, putting it in Morningstar’s 19th percentile for health-care funds. Over the past year, the fund has returned 11%, outperforming three-quarters of its Morningstar peers.

Welcome to TheStreet.com’s Fund Manager Five Spot, where America’s top mutual fund managers give their best stock picks and views on the market in a five-question format.

How will “ObamaCare” hit health-care stocks in 2011?

Gregory: Last year was a period of acrimony. We are now entering a period of compromise. With the Republicans resuming control in the House and narrowing the margin in the Senate, you are going to see health-care stocks and valuations improve.

What are your expectations for Big Pharma in 2011?

Gregory: Big Pharma is going to face continued headwinds. A lot of people are attracted to Big Pharma because of dividends. I like to look at returns of stocks net of dividends. As we look forward to 2011, the headwinds they are going to face include an increased excise tax to pay for reform, as well as continued pressure in Europe. Around 30% of pharmaceutical sales are in Europe. Unfortunately, Europe is instituting austerity measures, which will compress revenue growth.

We have seen a great deal of M&A in health care. Do you expect the consolidation to continue in the New Year?

Gregory: I do. Health care right now is very cheap. Health care trades at around 12 times EPS, whereas the S&P is at 15.3. So you have a relative 21.5% discount. Over the past decade, health care has traded at an 8% premium. So when you look for trends going forward, you have a cheap sector, you have constrained revenue growth, and that means that companies are going to look to acquire in order to generate earnings. The three areas I would consider are hospitals, life sciences and biotech.

If we see the consolidation you are expecting, do you think Big Pharma is going to buy smaller and smaller biotech companies? Maybe ones with drugs in Phase I trials as opposed to Phase III?

Gregory: I don’t think so. I think there is enough good product that is either late stage, Phase III or recently approved.

Consider the dynamic. Let’s say you have a spec pharma company with a drug that has recently been approved. In order to launch the product, they need to hire an entirely new sales force. If you are a pharmaceutical company, you can acquire that business. You don’t need a duplicative sales force by both entities, and that will improve the profitability of the product sold. And so, we expect to see continued acquisitions within later-stage spec pharma as opposed to early-stage biotech acquisitions.

Full Story – Here