The Pharmaceutical HOLDR (PPH) is an exchange-traded fund that tracks the shares of 21 of the world's largest drugmakers. The fund's largest holdings include (ticker symbol, weight in fund) Pfizer (PFE, 24.88%), Johnson and Johnson (JNJ, 20.53%) and Merck (MRK, 10.18%). Like all HOLDRs, the fund is comprised of a limited number of stocks. PPH's top 10 holdings account for nearly 93% of the fund's value. This means that you must be very cognizant of earnings and other announcements for each of the fund's individual holdings. It also means that it is a good idea to review the charts of the fund's largest components in order to get a feel for what the individual stock situations look like.

Why should you do this? Simple: You might see a developing reversal or continuation pattern that would give you reason to alter your outlook for the entire HOLDR. The other possibility is that one particular issue may be trading in the opposite direction relative to the rest of the fund. If this were a highly diverse ETF, then there would be no reason for action. However, in a situation where several issues account for 5% or more of the fund's value, you might wish to hedge that stock's weight in the fund. This can be done with a position opposite to the stock's slice of the fund, or with options.

It is very easy to determine how many shares you need to hedge. Merrill Lynch, which issues the HOLDRs, offers a wealth of information on its web site at http://www.holdrs.com. Here you'll find how many shares of each individual stock are contained within each 100-share lot of a given HOLDR. Unlike other ETFs, these numbers never change, except for by corporate action (splits, mergers and acquisitions, etc).

How important is this? Well, if you had a negative opinion regarding Merck prior to September 30, 2004, then you would have saved yourself a whole lot of money when MRK plummeted last week. PPH fell $2.89 that day, and its net asset value (NAV) tumbled $2.78. Of that loss, a full $2.65 was directly attributable to the sharp decline in Merck. If you had shorted 14 shares of Merck, then your losses would have been a fraction of a percent instead of more than 3%.

PPH holds many of the same stocks as the Healthcare SPDR (XLV). Its correlation though is only about 88% because XLV also includes other healthcare industry firms, such as HMOs. The fund does not closely track the Biotech HOLDR (BBH). PPH's correlation with that fund is just 63%--about the same as its correlation with the Nasdaq Composite (^COMPQ).

Pharmaceutical companies have had a long history of fruitful research and development (R&D). Despite the fact that the business is mature, the constant discovery of new drugs has allowed these firms to sport higher-than-average P/E (price/earnings) ratios. However, an uncertain regulatory environment has probably resulted in less effective and substantial R&D in recent years. This has led to a much smaller pipeline of new drugs on the horizon. Large drug companies also seem to have been quicker to drop their association with biotech firms, thus missing the opportunity to share in the revenue stream from new drugs developed by this up-and-coming industry. These issues will impact the returns for pharmaceutical stocks for years to come.

A quick reminder about HOLDRS...
HOLDRS, which are managed by brokerage giant Merrill Lynch, are a bit different from traditional ETFs in the way they trade and in their expense ratios. For example, you cannot buy or sell fewer than 100 shares of a HOLDR in any transaction. Instead, these unique instruments can only be traded in 100-share round lots. In addition, unlike most other types of funds, which track broad-based indices that contain hundreds (or some cases even thousands) of stocks, most HOLDRS consist of just a handful of stocks and are designed to track a particular industry group.

Because they only track a few companies, HOLDRS are very inexpensive to manage. However, because they aren't highly diversified, they also tend to be much more volatile than your average ETFs. HOLDRS also directly pass through any distributions the underlying securities make. This may lead to tax consequences different than what you would expect from an ordinary ETF. Note that because the fund's components never change, corporate restructurings and changes could ultimately result in a HOLDR no longer being representative of its original sector design. After purchasing a HOLDR, you will receive annual and quarterly reports from each individual company held by the fund.

HOW TO MAKE MONEY IN PPH THIS YEAR
There remains substantial risk in holding the shares of drug companies. As the U.S. quickly approaches a Presidential election, the winner will almost certainly have a large say in how the prices of these shares react. A win by Senator Kerry would almost certainly result in a knee-jerk negative reaction. The market would assume that Kerry would put further pressure on big pharma to reign in prices to American consumers. For years, U.S. buyers have footed the bill for R&D. By contrast, many foreign governments limit the prices that drug companies may charge.

This price imbalance has led to a new cottage industry. You can now buy many prescriptions from pharmacies over the border in Canada. The drug companies have bitterly fought this, as these drugs can cost 30% to 50% less (even with the Canadian dollar's recent appreciation against the U.S. dollar) when you buy them in Canada. Although it is illegal to resell Canadian drugs, the firms providing this service only act as an introducer to the Canadian pharmacy; they never touch the drugs. Individuals are permitted to bring in prescription items as long as it is for personal use.

The Food and Drug Administration (FDA) claims that that interpretation of the law is a stretch and that the consumer must actually buy the drugs in Canada, and not do it by mail, telephone or Internet order. However, given that more than one local government buys drugs for their employees via this route, this makes it highly unlikely that the FDA will succeed in promoting the more restrictive legal interpretation.

It is assumed that if Kerry is elected, he will more clearly permit drug re-importation (these drugs are often produced in the U.S., exported to Canada and then sent back, although some are manufactured directly in Canada). Alternatively, he may force the drug companies to sell at prices comparable to what they charge in the rest of the world. Either way, the result of any new regulation could spell trouble for pharmaceutical firms. Nationalized healthcare also certainly would not be a boon for the pharmaceutical industry.

Happily for the drug companies, as of the time this was written, it is looking more and more likely that President Bush will get re-elected (this is not a political statement on my part -- I am merely relating which president is seen as being better for the drug companies). As a result, several Wall Street firms have begun touting healthcare again. Certainly, a Republican victory would be a positive for the pharmaceutical industry. However, the price disparity between the U.S. and the rest of the world is not going to disappear, and ultimately, the U.S. government will likely take some action. Although it might take a Democratic administration, there will be one at some point in time. For that reason, the big drug companies are not likely to outperform the market over the long haul just on the basis of a Bush victory in November.

The withdrawal of the drug Vioxx by Merck took PPH down in what looks like part of, or possibly the end of, a fifth wave decline (based on Elliott Wave Theory, which I've written a book on and use heavily in my analysis). The fund's downside risk is limited to $70.25, or at worst, $66.90. From the likely low near $67.00, I expect the fund to rally at least $4.00. There is even a chance that PPH could ultimately soar back into the mid-$80 range.

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