There has been a notable rise in drug recalls over the past couple of years, including many high-profile cases. According to an analysis of FDA data there were 426 recalls in 2008, but an astounding 1,742 recalls in 2009. And although the pace has moderated this year, it’s still well above the 2008 level. The high-profile nature of some of the recalls including children’s Tylenol, Benadryl, and Motrin from McNeil, a subsidiary of Johnson & Johnson (JNJ - Free Analyst Estimate), has raised questions about the overall quality of domestic drug manufacturing. The high incidence and heavy dose of media coverage has clearly affected consumer’s perception of drug quality. Yet, despite apparent quality control issues throughout the industry, there are worthwhile distinctions from an investment standpoint.

Although the headline grabbing recalls have been from large, respectable companies like J&J, the bulk of the recent increased incidence is attributable to less sophisticated generic drug makers and repackagers. Indeed, one privately held repackager was responsible for over 1,000 of the recalls in 2009. The company, Advantage Dose, was also the recipient of numerous FDA violations and infringements regarding its plant and operating conditions. Meanwhile, generic maker, K-V Pharmaceutical wasn’t far behind in total recalls for 2009. The company went into a downward spiral following the recalls, with the bulk of its business being shut down, numerous fines and litigation, and the CEO being forced out. K-V’s stock plunged from over $20 in late 2008 to under $1, though it has recovered somewhat since then.

The generic drug industry has rapidly expanded in recent years, reflecting increased acceptance from retailers and consumers, alike. It has also benefited from the rise in patent expirations and Rx-to-OTC switches. However, generics have a high degree of susceptibility to quality and related issues due to the rushed nature of the ex-patent process, and the fact that many of these companies are relatively small and don’t have the resources of their larger brethren. In fact, a lot of the issues in recent recalls have little to do with the drugs themselves, but rather involve raw materials, faulty labeling, packaging, and contamination problems.  Even, large publicly-traded generic makers like Perrigo (PRGO) and Teva Pharmaceutical (TEVA), who have relatively strong track records in quality control, have been involved in some recent recalls. However, these stocks have performed well despite the recall news.

The pharmaceutical sector is generally viewed as a defensive investment, a relative safe-haven for investors. Although there have been situations where recalls and production issues have weighed heavily on stocks, we don’t believe that the recent rise in recalls warrants avoiding the stocks of high-quality pharma companies. Investors ought to focus more attention on a company’s revenue diversity or dependence on any one or group of products. For example, J&J’s stock price has held up relatively well despite the widespread nature and long duration of its recalls. This is primarily due to the company’s strong diversification, with Children’s Tylenol and other recalled products representing a very small part of its $60-plus billion in revenue. In fact, its entire OTC medicine segment accounts for less than 10% of revenues. Investors should also take into consideration the magnitude of actual or potential harm involved in the reasons behind the recall. In addition, smaller companies deserve greater scrutiny when it comes to the potential impact of a recall, and risk-averse investors, in particular, may want to stick to the larger, high-quality stocks within the sector.  

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.