Doc's note: After being out of favor for years, health care stocks have been on a tear since last fall. I've said that we're at the start of a new revolution in health care, which could lead some companies to huge gains.
But, as Joe Austin, a senior analyst at our corporate affiliate Chaikin Analytics, explains, there's a major problem in the pharmaceutical industry investors might be ignoring...
In the pharmaceutical business, there's always some race against time.
Companies first have to prove that their drugs are safe and effective before more people get sick... or even die.
Then they have to race to get their drugs to market before a competitor comes along with something better – or cheaper.
Once in the market, the company behind the drug has to make as much money as possible before the drug goes off-patent. That's called the patent "cliff" – when revenues start to decline.
And that patent cliff creates another race...
Pharma firms need to find new drugs to sell before their businesses start to decline.
That last race is the trickiest. And it's often the most expensive.
When it happens, drug companies have two options...
They can invest years in risky internal research and development (R&D). Or they can acquire promising drug candidates from other companies.
Patent cliffs are nothing new in the pharma world. But a huge one is underway...
In a report late last year, pharma-data firm Evaluate stated that more than $300 billion in drug revenues globally will lose patent protection between 2025 and 2030.
Early last year, Morgan Stanley warned that $175 billion in U.S. revenues alone were at risk. That's roughly 35% of the industry's total revenues.
By 2028, patents for more than 70 blockbuster drugs will expire. That would put nearly half of the top 10 pharma companies' revenues at risk.
But luckily, these firms have a huge war chest to deploy...
According to an analysis from Stifel late last year, the industry's 18 biggest players have about $1.2 trillion in cash and borrowing power to refill their pipelines.
A mergers-and-acquisitions (M&A) frenzy lies ahead.
But unlike past cliffs, there's a twist this time...
Big Pharma companies are no longer the main engines of innovation.
Most breakthrough drugs now come from small biotechnology firms. This means Big Pharma's $1.2 trillion will be chasing a limited pool of promising targets.
And competition for those assets will be fierce.
The winners will secure the next generation of blockbusters. The losers will burn through billions overpaying for mediocre assets or yesterday's science at tomorrow's prices.
For investors, this creates both opportunities and risks...
From Innovation Crisis to Shopping Spree
For decades, the pharma industry focused on internal innovation.
One study found that from 1984 to 2001, 89% of drug development happened internally rather than through external partnerships.
But the early 2000s flipped that script. Declining R&D productivity inside Big Pharma coincided with the emergence of nimble biotech startups that were out-innovating companies 100 times their size.
Between 1998 and 2008, small biotech companies discovered nearly half of all truly innovative new drugs. They also developed about 70% of new treatments for rare diseases.
And by 2007, biotech's share of blockbuster drugs (those with more than $1 billion in annual sales) increased from 8% to 22%.
Fast-forward to today, and the shift has accelerated.
According to consulting firm McKinsey, Big Pharma now relies heavily on outside innovation.
Since 2018, more than 70% of revenue from new drugs has come from products pharma companies bought or licensed from biotech firms rather than discovered in-house.
This shift from internal development to external sourcing has created a growing gap...
Some companies are skilled buyers. And others squander billions on bad deals.
McKinsey found that top performers in external drug acquisitions generate 3.4 to 8.2 times more value than bottom performers.
The buying frenzy has already begun...
In 2025, pharma M&A hit 585 deals worth $269.3 billion. That compares with the previous year's 452 deals worth $137.9 billion.
And with the patent cliff looming and the industry's $1.2 trillion war chest, this is just the beginning.
We're likely to see a big surge in dealmaking this year. And it's expected to include more than 20 acquisitions worth over $1 billion.
Watching Pharma and Biotech Firms in the Power Gauge
To keep an eye on all this, I'm watching two exchange-traded funds ("ETFs") in the Power Gauge...
As you know, ETFs hold baskets of companies. So they're a great way to gain broad exposure to a particular trend. They're also a great starting point for digging into individual opportunities.
First up is the State Street SPDR S&P Pharmaceuticals Fund (XPH)...
Right now, the Power Gauge gives the fund a "bullish" rating. And digging deeper, 18 of XPH's holdings are "bullish" or better. That compares with 35 in "neutral" territory... and five that are "bearish" or worse.
However, within the "neutral" holdings, 10 are rated "neutral+."
As regular readers know, a stock gets a "neutral+" rating when its share price moves below the long-term trend line. So despite a pullback, the Power Gauge still sees strength "under the hood" with "neutral+" stocks.
I'm also watching the State Street SPDR S&P Biotech Fund (XBI)...
It also earns a "bullish" rating in the Power Gauge right now. And 42 of its individual holdings receive a "bullish" or better grade... while 85 holdings are in "neutral" territory. And only 16 are "bearish" or worse.
Within XBI's stocks in "neutral" territory, 29 are rated "neutral+."
Put simply, the Power Gauge is already flagging strong opportunities on both sides of this M&A wave.
The patent cliff isn't a crisis. It's a catalyst for the biggest M&A wave pharma has seen in decades.
Companies that can identify the right targets and integrate them successfully should see their pipelines – and stock prices – soar.
There will be losers, too. But right now, this corner of the market is primed for action.
With $1.2 trillion in firepower and $300 billion in revenue to replace, the opportunity is too big to ignore. Pay attention to pharma and biotech stocks in 2026.
Good investing,
Joe Austin
