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I Would Buy a Generic Drug ETF, If One Existed

Seth is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

About 120 drugs have lost or will lose patent protection in 2013.  EvaluatePharma estimates that this accounts for nearly $29 billion in total annual revenue, a number which will grow ten-fold between now and 2018.  As big biotech and big pharma dive head-first off the patent cliff, there is suddenly an expanding market for cheap generic versions of blockbuster drugs of the past.  Investors looking to profit from growing sales of generic drugs could take a chance on one of the countless small- or mid-cap biotechs that specialize in generics, but not everyone is willing to take on that risk.  Here is why I would buy into a global generic drug ETF - if one existed.

The Opening for Generics

Pick a big drug company.  Chances are they will lose patent protection on one or more drugs soon, if they haven't already.  We'll start with the heavy hitters: Pfizer lost 70% of its revenue from Lipitor, the best selling drug ever, between Q3/2011 and Q3/2012.  Likewise, revenues for Sanofi's Plavix dropped 70% after only one quarter of generic competition.  This year Eli Lilly will lose Cymbalta ($4.9 billion in 2012), after losing Zyprexa last year; Biogen Idec loses Avonex ($2.9 billion in 2012); privately owned Purdue loses OxyContin ($2.3 billion) - you get the point.  While generic competition will drive down these prices and the value of the market as a whole, patent expiration opens the door for new generic manufacturers to grasp market share.  Some of these generics, like the abuse-resistant version of OxyContin produced by Actavis, will actually be innovative enough to outperform their predecessors.

A recent decision by India's Supreme Court also paves the way for generic drugs in emerging markets. In April the court denied Novartis (NYSE: NVS) patent protection for the cancer drug Gleevec. In an interesting twist, Novartis had already provided 16,000 patients with $1.7B worth of free Gleevec.  Novartis' issue is therefore not with its bottom line in India, but rather the precedent set for Indian generics to be sold in third party emerging markets.  Along with failed intellectual property cases by Bayer and Roche, the case against Novartis highlights the sales potential of a global generic drug industry in emerging markets.  That's why if a global generic drug ETF existed, I would buy it.

The Risks

There are inherent risks in investing in single pharmaceutical/biotech companies, and diversification is always the best course of action.  Those risks are only amplified when considering companies attempting to break into the generic drug market.  The majority of these companies are small with high degrees of volatility and poor profit margins. They face ruthless competition from big biotech and big pharma, who are out for blood to cover tumbling prices and lost market share.

Even larger and more established firms have their pitfalls. Take Teva (NYSE: TEVA), for example.  With a $33 billion market cap Teva is one of the largest generic drug companies in the world, but it is a company in transition.  Around 20% of its revenue came from its branded Multiple Sclerosis drug Copaxone (subcutaneous injection), which will lose patent protection in 2015 and faces stiff competition from Biogen's oral drug Tecfidera. It is also facing growing pressure from generic competitors like Mylan Laboratories.  Not to mention, Teva has faced legal action over infringement of Pfizer's Lipitor patent in the UK.  Barr Laboratories, a division of Teva, also recently lost a suit against Allergan over patent protection of Lumigen.  The Generic Pharmaceutical Association estimates that over 50% of generic drug firms lose patent challenge suits.  As an investor, I don't like those odds.  While we can hope that revenues from Teva's growing generic drug division will compensate for it's waning Copaxone revenues and legal woes, it would still be preferable to diminish that risk by investing in the generic drug industry as a whole.  That's why if a global generic drug ETF existed, I would buy it.

A Generic Drug ETF

The major biotech ETFs have had great runs over the last two years.  iShares Nasdaq Biotech (NASDAQ: IBB), Market Vectors Biotech ETF (NYSEMKT: BBH), and SPDR S&P Biotech (NYSEMKT: XBI) are all up 50%-100% over the last two years. While these ETFs provide widespread access to the industry, they each list at least three of the "big four" biotechs in their top ten holdings (to be fair, SPDR Biotech does give equal weight to small- and large-cap biotechs).  In fact, Market Vectors and Nasdaq Biotech have done so well partly because Amgen and Gilead combine for 28% and 17% of total assets, respectively.  This is not to say these ETFs should be avoided.  It does seem likely that these funds will find continued success as big biotech and big pharma continue to innovate, but they don't provide the kind of coverage you're looking for if you want to invest specifically in the growing generic drug market.  An ETF dedicated to tracking the global generic drug market will provide investors with exposure to a growing source of revenue while mitigating the risks of investing in single companies.  That's why if one existed, I would buy it. 

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Seth Robey has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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