I remember how nutty investors were for shares of the big pharmaceutical companies 15 years ago. Pfizer (NYSE: PFE) had just put the spark back into middle-aged marriages, thanks to its failed blood pressure med that had a surprisingly pleasant side affect. Other companies followed suit with similar remedies.

See, the biggest portion of the U.S. population, the Baby Boomers, were in their early to mid-40s. In five to 10 years, they would need all kinds of drugs in addition to the recreational, gentlemen’s vitamins. Blood pressure, cholesterol, anti-inflammatory meds, you name it — Big Pharma was cranking it out.

The stock prices reflected that ambitious optimism: multiples were quite sporty. Well, 15 years ago, most stock multiples were sincerely out of whack, and Big Pharma was no exception. Listening to analysts and chatting with health care fund managers, we were told that if you could buy a big pharmaceutical company like Pfizer or Merck (NYSE: MRK) at a price-to-earnings (P/E) ratio of 24, it was considered a bargain. What a difference a decade and a half makes…

Up until recently, the big drug companies had P/Es at depression-era single digits. There were a bunch of reasons, but the specter of health care reform was one of the primary ones.

Well, the toothpaste can’t be put back in the tube: Obamacare’s a done deal. And the drug manufacturers did OK on the deal. Now, it’s time for investors to go shopping. There’s plenty of high quality value around.

My favorite is the venerable and, lately, much maligned Eli Lilly (NYSE: LLY).

Most investors are fearful — that means you should be greedy…
Looking at Eli Lilly, Warren Buffet’s words ring true. While the herd wrings its hands, you can pick up shares at a paltry trailing P/E of about 8.5 and a forward P/E of about 8.8.

Why is the herd so nervous? Aside from the fact that they’re the herd and that’s their job, the somewhat educated reason is patent expiration. Lilly’s star anti-psychotic drug, Zyprexa, which contributed $5 billion in revenue in 2010, comes off patent in October of this year. Gemzar, a popular anti cancer drug responsible for $1.1 billion in revenue in 2010, also goes generic this year. But smart companies plan and Lilly is a smart company.

CEO John Lechleiter, is a Lilly-lifer. Starting as a chemist in the research and development (R&D) lab, Lechleiter spent the past 35 years working his way up through the ranks to the top slot. There’s little question of his commitment: he lives less than a mile from Lilly’s headquarters in downtown Indianapolis and walks to the office daily.

Dr. Lechleiter (he has a doctorate degree in organic chemistry from Harvard University) has set a course that pays homage to what makes a drug company great: developing new drugs. Currently, Lilly has 68 new drugs in the pipeline, 34 of which are in Phase I or II testing or under regulatory review. The other half is almost across the finish line. But all it takes is one blockbuster to knock the numbers over the fence. In 2010, Lilly’s R&D spending totaled $4.4 billion, which is roughly 18% of sales for the same period. That’s one of the highest R&D-to-sales ratios in the drug industry.

Lilly’s peers are making acquisitions to build their respective pipelines, but the company sees more value in developing its pipeline organically. I agree. Meanwhile, other divisions such as veterinary, which is growing sales at 10%, can help pay the bills.

Lilly generates plenty of cash to finance the pipeline. For 2010, the company cranked out $7 billion dollars of operating cash flow, which is more than enough to cover capital expenditures and the dividend, which now sits at a compelling 5.3% yield. Lilly finished up 2010 with nearly $6 billion in cash on its balance sheet.
 
Action To Take –> Liking shares of Lilly doesn’t seem to be the most popular opinion. But operating cash flow has more than doubled in the past decade, from $2.9 billion to $7 billion, while earnings per share (EPS) have gone from $2.58 to $4.58 last year. Meanwhile, the P/E has shriveled from 37 to 8.5.

One side of the market is wrong. As is often the case, I think it’s the herd.

I’ll go out on a limb and say a 12-month price target of $47 makes sense based on a 27.5% expansion of the P/E (that would bring it up to a mere 10.7 times earnings). Throw in the handsome 5.3% dividend, and the potential total return comes in around 32%. That’s a pretty good pay off for going against the grain.

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