Turnaround time for pharmaceuticals?

"You can invest for all the right reasons and still get the wrong result," says George Putnam, referring to the poor performance of the pharmaceutical sector in recent years.

Here, in his industry-leading The Turnaround Letter, he offers a fascinating review of 10 leading drug stocks which he now believes offer a combination of growth potential at "pretty cheap" valuations.

"In 2000 and 2001, when the Internet boom was becoming a bust, many smart investors turned away from technology stocks and put their money into drug stocks. How could you go wrong with the big pharmaceutical companies?

"Demand for their products was growing as the population aged. These companies had huge research and development programs that seemed to keep cranking out new blockbuster drugs. And most of them had great balance sheets, with many paying handsome dividends.

"Much of this reasoning has been borne out in the intervening years. Many large drug manufacturers have rung up substantial revenue gains over the last decade. So what’s happened to the big drug stocks? With few exceptions they have gone sideways or down – in some cases down a lot.

"What happened? With the benefit of hindsight, we can see that while they were indeed great companies (and still are), their stocks were overvalued. Investors gradually realized that these companies did face risks – generic competition, shifting regulatory winds and product liability lawsuits, to name a few.

"Now, as often happens, the markets may have gone too far in the other direction, and the big drug stocks look pretty cheap. The growth potential is still there, but the risks are pretty well priced into the stocks.

"Moreover, many of the dividends are even richer today, which gives you some downside protection in case the markets remain volatile. We highlight below ten large pharmaceutical makers whose stocks look particularly attractive to us right now.

"Abbott Laboratories (NYSE: ABT) recently reported quarterly results that showed double-digit revenue and earnings gains.

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"But the stock has sold off to trade near its lows of the last 16 months and only marginally higher than levels of early 1999! With a forward P/E below 15 and a dividend yield of 2.9%, Abbott is well priced to reward patient investors.

"AstraZeneca (NYSE: AZN) has gone nowhere for a decade, despite revenues having grown from $5.5 billion to $29.6 billion. The major difference being that investors in 1999 were willing to pay as high as 75x earnings, but now are unwilling to pay even 10x expected earnings for 2008.

"In addition to the industry’s general malaise, AstraZeneca has some integration issues from recent acquisitions. But once it sorts those out, the stock should perform well.

"Bristol-Myers Squibb (NYSE: BMY) is streamlining. It recently sold its medical-imaging unit and plans to divest half of its 27 manufacturing facilities, cut its work force by 10% and spinoff up to 20% of its nutritionals business.

"Meanwhile, it is also building a pipeline of new products. With the stock recently trading at the same level it did in 1991, it seems that mainstream investors have given up on Bristol-Myers, which provides an opportunity for those willing to go against the crowd.

"Eli Lilly & Company (NYSE: LLY) is generally recognized for having a more diversified drug portfolio and a deeper pipeline than many in the industry. Nevertheless, the stock trades at low multiples right along with its industry peers.

"Management isn’t sitting idle. In addition to spending a formidable 18.7% of sales on developing the firm’s pipeline, it is also pursuing strategic acquisitions.

"The valley at GlaxoSmithKline (NYSE: GSK) appears to be about 18 months to two years wide. That’s how long it will take, according to the company’s CEO, for it to be marketing newer products and for generic competition to erode.

"In the meantime, management is making acquisitions to build out its portfolio and streamlining operations in order to sustain profitability. In case you have to wait a bit for GlaxoSmithKline’s stock to rebound, there is an attractive 5.7% dividend yield.

"Johnson & Johnson (NYSE: JNJ) is seen as a more stable competitor due to a more diverse operating base.

"Pharmaceuticals account for about 41% of total sales, with medical and diagnostic products at 35% and consumer personal care products at 24%. The stock has acted better than most, but it has made little net progress in the last six years.

"Merck (NYSE: MRK) has faced formidable headwinds ever since it was forced to pull Vioxx from the market in 2004. More recently, the firm’s Vytorin and Zetia have faced challenges to their effectiveness, and Fosamax is facing increasing generic competition.

"Not surprisingly, the stock has taken a hit, falling more than 30% from its January 2008 level. But based on cost-cutting initiatives and sales of its cervical-cancer vaccine, Gardasil, management recently reaffirmed earnings guidance. Maybe the glass is half full.

"Pfizer (NYSE: PFE), the world’s largest pharmaceutical company, reported disappointing quarterly results that pushed the stock below $20 for the first time since 1997.

"Competition for two of its leading products Norvasc (blood pressure) and Zyrtec (allergy), strict labeling requirements for Chantix (Pfizer’s newer antismoking medication) and lackluster sales for Lipitor combined to hurt results. With a forward P/E below 8, it would appear that investors are assuming a pharmaceutical Armageddon.

"The latest quarterly results at Schering-Plough (NYSE: SGP), according to at least one article, 'trounced Wall Street expectations.' And, indeed, the stock has rallied a bit, but only after it had fallen to its lowest price since 1996.

"The results benefited from more rapid assimilation of last year’s $14.5 billion acquisition of Organon BioSciences, strength in the U.S. dollar, overseas demand, growth in the firm’s animal health segment and revenues from its joint venture with Merck covering Vytorin and Zetia. Despite the good news, the stock is off more than 40% from its level a year ago.

"Wyeth (NYSE: WYE), formerly American Home Products, continues to struggle with product liability issues and generic competition.

"Management is rethinking the company’s business model. But there are bright spots in the outlook, including the recent approval of the firm’s Pristiq antidepressant drug and a new drug pipeline that offers significant diversity."