3 Drug Stocks to Buy at a Discount

Over short periods, Wall Street is largely driven by emotions. When there's a compelling story, such as the emergence of GLP-1 weight loss drugs in the pharmaceutical sector, investors tend to become overly excited.

Eli Lilly's (NYSE: LLY) industry-leading GLP-1 drugs have netted it a price-to-earnings ratio (P/E) of 53. Other well-respected drugmakers, meanwhile, have been left to languish. This is why contrarian investors should take a look at Merck (NYSE: MRK), Bristol Myers Squibb (NYSE: BMY), and Pfizer (NYSE: PFE) today.

Far below average valuation

Eli Lilly's 53 P/E ratio is huge. The stock price advance that led to that valuation has pushed the dividend yield down to a shockingly low 0.6%. The average P/E for the drug sector is roughly 30, with an average yield of around 1.3%. From a valuation perspective, it's pretty clear that investors are affording Eli Lilly a premium price.

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There are other large and historically successful drugmakers that aren't trading at a premium. For example, Merck's P/E ratio is 14, and its dividend yield is 3.2%. Bristol Myers Squibb's P/E is 18, and its yield is 4.7%. And Pfizer's P/E ratio is 15 while its yield is 6.8%. If you look at these valuations, these three drugmakers appear to be trading at a discount.

There are good reasons for the relatively low valuations being afforded to Merck, Bristol Myers Squibb, and Pfizer. However, these are companies that have consistently proven over time that they can discover, develop, and market innovative drugs. The problem is that innovation doesn't always happen on a set schedule.

Normal problems in a competitive industry

The most notable emotional headwind Merck, Bristol Myers Squibb, and Pfizer face right now is that none of them has a strong GLP-1 weight loss drug on the market. For better or worse, Wall Street is hyper-focused on this new class of drugs.

There are very good reasons for this, given the potential of the market. However, weight loss isn't the only thing that drugmakers are looking to tackle. There are many other important applications for drugs, like cancer and many other illnesses.

While Pfizer is clearly trying to compete in the GLP-1 space, noting a recent acquisition in the area, Merck and Bristol Myers Squibb are largely focused on other conditions. If you can look past the headlines, you see that Merck, Bristol Myers Squibb, and Pfizer are all important industry giants in their own right.

That said, all three are facing patent cliffs. A patent cliff occurs when a blockbuster drug loses patent protection and generic versions of the drug come out. The generic versions often see rapid adoption, leading to a steep decline in revenue for the drug that lost patent protection.

Patent cliffs are a problem but a normal part of doing business in the pharmaceuticals sector. Merck, Bristol Myers Squibb, and Pfizer have all successfully navigated patent cliffs before.

The real issue is that the research and development of new drugs doesn't always align well with patent cliffs. There are often periods when a drug company's sales are weak as new drugs move through the approval process.

That's not the ideal outcome, but it happens. Wall Street appears concerned that Merck, Bristol Myers Squibb, and Pfizer may have gaps between their patent cliffs and the release of new blockbuster drugs.

That might, indeed, be what happens, and it will still be a completely normal event. If history is any guide, Merck, Bristol Myers Squibb, and Pfizer will likely navigate the headwinds and remain strong long-term performers in the highly competitive pharmaceutical sector.

There's a risk spectrum to consider

One of the key draws for investors considering Merck, Bristol Myers Squibb, and Pfizer will be their above-average dividend yields. Conservative investors should probably go with Merck's relatively low 3.2% yield, given that it's supported by a fairly solid 45% dividend payout ratio.

Bristol Myers Squibb comes in second on this metric, with a payout ratio of 85% backing its 4.7% yield. That leaves some breathing room for the dividend, but it should be watched carefully. Pfizer has the highest yield of the group at 6.8%, at least partly because its payout ratio exceeds 100%. It's probably best for more aggressive investors.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Bristol Myers Squibb, Merck, and Pfizer. The Motley Fool has a disclosure policy.