Drug stocks have been under the weather this year -- even compared with the sickly performance of the broader stock market.

Investors are worried about drug pipelines, competition from generics and U.S. legislators who want to limit drug costs.

Last week, marquee drug maker Eli Lilly and Co. further unsettled investors' stomachs when it advised analysts to lower earnings projections.

Analysts now expect fiscal year 2002 earnings to come in at between $2.55 (U.S.) and $2.57 a share instead of $2.60 to $2.62.

Morgan Stanley analyst Jami Rubin likens what seems like a never-ending stream of earnings warnings from Eli Lilly to slowly peeling off a Band-Aid.

She notes that the latest warning marks the fourth time since July, 2001, that Lilly has advised analysts to adjust their forecasts.

Ms. Rubin cut her earnings forecast for 2003 to $2.67 a share from $2.80.

But Eli Lilly chief executive officer Sidney Taurel pointed out that the third quarter marked a return to quarterly earnings growth for the company and said increased competition for Eli Lilly's blockbuster anti-depressant, Prozac, will have a smaller impact on future results.

"We are now through the period during which the Prozac sales decline triggered by generic competition in the U.S. had the greatest impact on our performance," Mr. Taurel said in a statement.

But Ms. Rubin believes that investors who buy Eli Lilly shares are not being compensated for the risk, given that at recent levels, the stock has traded at a 30-per-cent premium to its peers.

She rates the shares "equal weight."

Eli Lilly shares closed at $56.95 on the New York Stock Exchange on Friday, up $1.24.

Salomon Smith Barney Inc. analyst George Grofik says Eli Lilly's third-quarter profit of 68 cents a share was 1 cent better than his expectations.

Sales were lower than expected, but the company was able to cut costs to boost earnings, he notes.

Mr. Grofik believes Eli Lilly has one of the best drug development pipelines in the business, but he rates the shares "underperform" because they are "priced to perfection."

Drug stocks have lagged the broader market over the past two years, Mr. Grofik says.

An unprecedented wave of patent expirations, a surprising period of lacklustre research productivity, a stricter regulatory environment and continuing political risk caused pharmaceuticals to underperform the market by 12 per cent over that period, he calculates.

Mr. Grofik believes that the threat posed by generic drug makers as big pharma companies see some blockbuster drugs lose patent protection is the biggest reason for the group's mediocre performance.

That risk factor for the group will lessen considerably in 2003, Mr. Grofik says, with between $2-billion and $8-billion worth of drugs losing exclusivity.

Also, the regulatory environment appears to be improving, he says, with U.S. regulators taking steps to speed up new drug approvals.

Mr. Grofik also thinks the sector's profit performance will improve compared with the broader market next year.

In 2002, he notes, drug companies' earnings per share are expected to decrease for only the third time in the past 42 years. The projected 2.3-per-cent decline in earnings from 2001 would fall short of the growth rate of Standard & Poor's 500 companies by about 9 per cent.

By comparison, in 2003, Mr. Grofik expects the drug group's earnings to underperform the S&P 500 by only 4 per cent.

"Further deterioration in the U.S. economic outlook is bullish for drug stock performance," Mr. Grofik says.

The analyst acknowledges that U.S. pharma sales are not likely to return to the strong growth of more than 25 per cent annually they saw in the late 1990s.

As a result, he does not expect the group's stocks to again trade at a 25- to 50-per-cent premium to the S&P 500, as they did during the big growth years.

Historically, drug stock valuations have ranged between about a 10-per-cent discount to a 50-per-cent premium to the broader market, he notes.

Drug manufacturers still face challenges: Notably, the U.S. government has been passing legislation aimed at controlling soaring drug costs and may close more loopholes.

Also, earnings shortfalls at some of the big companies could drag down the entire group, Mr. Grofik warns.

These factors could combine to put a lid on drug price-to-earnings ratios in 2003, he says, and he rates the group "market weight."

He believes drug stocks are fairly valued where they are. But he notes that trading is sometimes volatile, and he recommends that investors who want to trade the stocks buy them at about a 10-per-cent discount to the S&P 500 and take profits when the group approaches a 25-per-cent premium.

His top picks are Pfizer Inc., Pharmacia Corp. and Wyeth Ltd.

Merrill Lynch & Co. Inc. analyst Daniel Lemaitre recently reiterated his "buy" rating on shares of Johnson & Johnson.

Mr. Lemaitre points to the drug giant's third-quarter sales, which jumped 13 per cent from the same period last year. Earnings of 60 cents a share were better than his forecast of 58 cents.

Mr. Lemaitre expects sales growth to continue at the same pace in 2003.

Bottom Line: Drug stocks have not fared well in 2001 and 2002. Some analysts are predicting a better performance in 2003, but they do not expect the group to return to the robust growth that it enjoyed in the late 1990s.