Pharmaceutical stocks, which have soared in the past year to valuations not seen since 2001, are poised to extend their rally as investors grow more confident the industry has weathered a decade-long shortage of new drugs.

Large pharmaceutical stocks such as Sanofi, Novartis AG and Pfizer Inc. are still cheaper relative to next year’s estimated earnings than are market benchmarks such as the U.S.’s Standard & Poor’s 500 Index, according to data compiled by Bloomberg.

A fundamental change in the way pharmaceutical companies are positioned leaves room for shares to erase that gap and rise another 20 percent in two years, said Ori Hershkovitz, a partner at Sphera Funds Management Ltd., a health-care hedge fund in Tel Aviv. Companies have become more diversified — in geography and products — and have built stronger pipelines of experimental drugs even as the U.S. Food and Drug Administration approved 39 new drugs last year. That’s the most since 2000, according to Bloomberg Industries data.

“It’s not a simple comeback,” Hershkovitz, who owns Pfizer and Sanofi shares, said in a telephone interview. “It’s of historical magnitude because they’re changing the business model. It’s not pharmaceuticals as we knew it. It’s new companies.”

Drugmakers, hard hit for years by a paucity of new drugs and expiring patents for big money makers, have turned the page. They have have slashed payrolls, built their presence in new markets, and moved from a reliance on single mega-blockbusters to a push for many smaller products.

Eliquis, Afinitor

Research and development have revived too. Among the drugs approved by the FDA last year are Eliquis, a blood thinner from Pfizer and Bristol-Myers Squibb Co., and new uses for Novartis’s cancer drug Afinitor. Several more new drugs, moreover, may receive FDA approval this year.

Sanofi now gets less than 5 percent of its sales from chemical compounds with patents that are due to expire in the U.S. and Europe over the next seven years, according to the company. Pfizer, which had the world’s top-selling drug in the cholesterol medicine Lipitor, gets less than a 10th of its sales from its biggest product, data compiled by Bloomberg show. At Lipitor’s peak sales of $12.9 billion in 2006, it accounted for 26 percent of the New York-based company’s revenue.

Higher Multiples

Stock prices have followed. Pfizer shares surged 27 percent in the past year, Sanofi gained 29 percent, Novartis rose 22 percent, Eli Lilly & Co. jumped 38 percent and Roche Holding AG rallied 24 percent. The average large-capitalization drug company sold for about 23 times earnings on a trailing basis as of yesterday’s close, the highest since 2001, according to data compiled by Bloomberg. Excluding Japanese companies from the global average, U.S. drugmakers are at their highest level since 2007, while their European peers have climbed past 2010 levels.

Investors still underestimate the industry, and will be willing to pay a higher multiple of earnings for the shares, Sanofi Chief Executive Officer Chris Viehbacher said in an interview with Bloomberg Television last month in Davos, Switzerland.

“The whole industry is still poised for a re-rating,” he said. “People have started to recognize the value of our diversified model, and I think the future increase is going to come from the research and development pipeline, which is underestimated.”

Rising Valuations

Sanofi shares sold for about 8.2 times estimated earnings at the end of 2009 as Viehbacher finished his first year on the job. The stock now fetches about 10.9 times estimated 2014 profit, and the company said last week earnings growth should resume in the second half of this year as patent expirations recede into the past.

Novartis sells for 12 times estimated 2014 earnings and Pfizer is priced at 11.4 times, compared with a multiple of 12.5 for the S&P 500.

To be sure, price-earnings multiples for pharmaceutical stocks already rose 23 percent in the past two years, Bloomberg Industries analyst Sam Fazeli wrote in a Feb. 6 report. Meanwhile, analysts have become less bullish on the stocks since mid-2011, perhaps in reaction to rising valuations, Fazeli wrote.

For price-earnings multiples to continue to rise, “the everyday investor has to have confidence in the sustainability of earnings growth,” said Tim Race, a London-based analyst with Deutsche Bank.

“It’s a slow process,” Race said in a telephone interview. “I’m not expecting the sector to re-rate massively overnight. We need to see more evidence of sustainability.”

Race put Bayer, Sanofi and Roche atop his list of pharmaceutical stock picks for 2013.

Generic Competition

The drug company revaluation has been a long time coming. Investors had punished drug stocks for a decade as their pipelines ran dry and blockbuster drugs such as Pfizer’s Lipitor cholesterol-lowering pill, the asthma treatment Singulair from Merck & Co. and Sanofi’s Plavix blood thinner lost patent protection and faced generic competition. Companies failed to get enough promising medicines through clinical trials, or to win regulatory approval once testing was completed, to replace the lost revenue.

The average price-earnings multiple for large pharmaceutical stocks contracted from about 48 in 1998 to about 15 a decade later, according to data compiled by Bloomberg based on trailing earnings.

Optimists say that last year’s gains may get a renewed push with another wave of drug approvals. The FDA is expected to rule this year on Roche’s breast cancer drug T-DM1 and Biogen Idec’s multiple sclerosis treatment BG-12, and GlaxoSmithKline Plc is facing decisions on five products including the lung drug Relvar.

“The proof of the pudding is in the products,” Race said. “People need to see pipeline success this year and next to really believe.”

(Source: Bloomberg)