Which Pharmaceutical Stock Should You Invest In? – Pfizer Inc. (PFE), Merck & Co., Inc. (MRK), Eli Lilly & Co. (LLY)

A common trap many investors fall into is becoming overly confident in their views. This leads to wagering too much on a single outcome.  We all know these investors – those who just ‘know’ a stock they are going to invest in is a ‘sure thing’ or a ‘gift from God investment.’  We also all know how this typically ends–the investor trying to explain to his wife why they lost the kid’s college funds on that ‘sure thing!’

Where most people go wrong is not in their view, but how they apply their view.

The pharmaceutical industry is a perfect example of this. Many an investor has confidently bought a pharmaceutical stock only to see it fall sharply because promising drug trials failed.

It may be worthwhile considering a different approach to applying your view. Instead of investing a big chunk of your capital into just one ‘sure thing,’ why not invest a small amount of capital into several long dated call options on a variety of stocks?

Consider this scenario: your view is that over the next two years several pharmaceutical stocks have promising upcoming trials. You reason that at least one of them is likely to perform well and create a significant price appreciation.  The only problem is choosing which one will it be. You could buy Merck & Co., Inc. (NYSE:MRK), yet it might be Pfizer Inc. (NYSE:PFE) that has the blockbuster results and you miss out completely. You watch from the sidelines while Pfizer investors cheer as their stock doubles.

Well, investing in LEAPS may be a low cost answer to avoiding that, and can give you a finger in each pie without risking blowing up your retirement funds.

As an example, imagine you have $20,000 to invest. You could take approximately 1% of your capital and invest in LEAPS on several pharmaceutical stocks.

With volatility so low in the present environment, you can get a significant amount of exposure to the upside without risking a great deal.

Pfizer Inc. (NYSE:PFE), currently priced around $26, has an option market offering the Jan. 2015 $27 Call for just $2.20. If Pfizer Inc. (NYSE:PFE) produces a breakthrough trial, it may well see $40 before Jan. 2015, delivering you a profit of some $1,300 per contract.

But what if Pfizer Inc. (NYSE:PFE) fails and nothing spectacular happens? Well, you will lose $220, but you have nearly 2 years of being positioned for any upside.

I feel the majority of the market is aware of (and therefore has priced in) the issues Pfizer Inc. (NYSE:PFE) is facing with expiring patents, staring down it’s own patent cliff.

When I look at what I consider to be fully priced in headwinds and the potential tailwinds for Pfizer Inc. (NYSE:PFE), I am bullish. The potential tailwinds I speak of are the upcoming products Xalkori and Eliquis. These two products look as though they have significant potential, potential that I feel is over-discounted in the pricing of Pfizer.

Over-pricing of headwinds and underpricing of tailwinds, combined with low option volatility, make Pfizer a clear buy for me.