Since I first wrote about my idea for a new generic drug exchange-traded fund (ETF) nearly two years ago, the global index of 80 stocks has been a strong performer as it catches up with the strong underlying fundamentals for the generic drug industry which are outlined below.

1.) approximately 70% of all prescriptions in the U.S. are filled with generic drugs;

2.) IMS Health estimates $135 billion in branded drug sales (including $90 billion in U.S.) will face generic competition / patent expiration over next five years (including blockbusters such as Lipitor and Plavix);

3.) IMS Health estimates $42 billion in global generic drug sales in 2011, representing growth from an expected $28 billion in global sales in 2009 and $17 billion in 2008;

4.) IMS Health estimates that the generic drug industry is growing at 7.8%, which is a faster pace than the worldwide market for pharmaceuticals; and

5.) the National Association of Chain Drug Stores estimates that in 2007 the average retail price of generic prescription drugs was $34.34 as compared to a much higher (over 3X) average price for brand name drugs at $119.51.

The HavRx Global Generic Drug Index is passively managed and tracks the performance of companies which meet any of the following three requirements:

1.) Derive either $500 million (USD) OR more than 50% of trailing 12-month revenue from the manufacture and sale of any type of generic (off-patent) prescription or over-the-counter (OTC) drug product intended for use by humans, including contract manufacturing services, active pharmaceutical ingredient (API) suppliers, and intermediate product suppliers for drug products and biological agents;

2.) Have one or more compound(s) in active clinical development OR have a pending ANDA with the FDA for a generic drug candidate; and

3.) Receive FDA approval for an ANDA within the past 12 months. The index excludes all companies that derive over 50% of trailing 12-month revenue from the sale of patent-protected or legacy brand prescription or OTC drug products.

Approximately 75% of the companies in the index are based outside of the U.S. (including many small / mid-cap stocks based in China and India), which strengthens the case for a Global Generic Drug ETF since it would provide average retail investors with a cost-efficient means to trade the entire industry in a single investment vehicle. The accompanying tables include statistics for a semi-active generic drug ETF that would be rebalanced on a quarterly basis and equally weighted among active components with a market cap of at least $200 million and three-month average daily trading volume of at least 30,000 shares, in addition to the 15 largest index components by market cap.
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As of late November, 55 of the generic drug index component stocks met these requirements with an average stock price gain of approximately 95% over the past year and over 15% gain for the entire index in the past three months. Generic drug stocks have outpaced the overall healthcare sector and related ETFs, such as the PowerShares Dynamic Pharma (PJP), iShares DJ US Pharma (IHE), Pharma HOLDRs (PPH), S&P Pharma SPDR (XPH), Healthcare Sector SPDR (XLV), iShares Nasdaq Biotech (IBB), and SPDR S&P Biotech (XBI).

A Global Generic Drug ETF would also provide instant, diversified access to the small / mid-cap generic drug makers and suppliers that are tracked in this index and the subject of possible acquisitions by leaders in the industry such as Teva Pharma (TEVA), Mylan (MYL), Watson Pharma (WPI), and even big pharma companies such as Novartis (NVS) and Pfizer (PFE) that have significant generic drug divisions.

In 3 of the past 4 market rebounds since 1982, equity gains slowed to a single-digit pace in the second year, after the initial rally. Now dividend stocks have extra appeal because they offer a tempting alternative to CDs, which pay virtually no interest at all, and long-term bonds, which pay a little bit more but leave you at the mercy of inflation.

Established value companies in stable industries have usually proven a better long-term investment. Before S&P cut Pfizer (PFE) ratings to 'AA' from 'AAA' on Oct 16, 2009, there were 5 companies with AAA credit ratings: Pfizer plus Automated Data Processing (ADP), Johnson & Johnson (JNJ), ExxonMobil (XOM) and Microsoft (MSFT). In other words, 2 out of 5 were healthcare companies.

I covered healthcare plans stocks such as UnitedHealth Group (UNH) in my Oct 25 article. Following are major healthcare companies in other subsectors inside the health care sector, sorted by yield:

The top 8 companies in the above list yielding more than 3% are all major drug manufacturers. Some of them have single digit forward P/E. H1N1 could benefit vaccine-makers including Novartis (NVS), Sanofi-Aventis (SNY), and AstraZeneca (AZN). On November 25, U.S. health officials said that they are seeing a worrying pattern of serious bacterial infections in swine flu patients, mostly among younger adults not normally vulnerable to them.

In addition to pending health care reform, a common problem facing big pharma is that there are patents which will expire between 2010 and 2012. However, this industry has been looking to fuel growth via acquisitions, including blockbuster deals. Pharmaceutical giants are also looking to pick up some biotech companies to boost their pipelines.

Biotechnology probably offers the best level of innovation of any of the healthcare industries. Its P/E is low too. For example, Amgen (AMGN)’s P/E is only 12.

Although my core holdings are boring blue chip dividend stocks, I also allocated a very small portion of my portfolio in promising small caps. China Biologic Products (CBPO.OB) is one of the leading plasma-based biopharmaceutical companies in China. For the first nine months of 2009, its total revenue was $81 million, up 142% from 2008. It has $50 million in cash and low debt. However, traded in OTC bulletin board, the stock price was extremely volatile. It also has derivative liabilities which might potentially affect its future income.

During the relatively benign 20-year period prior to 2008, most portfolios accumulated considerable short volatility biases, which looked very attractive to investors as a result of recent positive performance. It was this growing short volatility bias that created so much pain in the current downturn, according to CFA Digest November 2009 issue.

Buying after a 40% decline is not a safe bet for investors. Markets may continue to fall and often have no trouble reaching a bottom of 75% below peak. Recent examples include 1989’s Japan Nikkei index, 2000’s NASDAQ, 2007’s China market and 2008’s oil/natural gas prices. So if investors think the environment will remain volatile, they should look for stocks with a lower sensitivity to volatility. Even if they make fewer profits for you on the way up, they lose a lot less on the way back down.

With its forward average P/E of 12 and beta of 0.69, healthcare might be a great defensive sector. For those who need stable income, big pharmaceutical companies may be a good choice.