Moody’s Investors Services recently gave the global pharmaceutical industry a negative outlook for the next 12 to 18 months, in large part due to the patent expirations of major drugs in 2011 and 2012. Some drug companies are already dealing with the effects of patent expiration and are increasing expansion efforts and merger-and-acquisition activity to replace lost revenue.

What drug patent expirations make the pharmaceutical sector less attractive for investors?
The patents on many of the world’s leading drugs are set to expire in 2011 and 2012, paving the way for lower-cost generic drugs. Top-selling drugs like Lipitor, the world’s leading cholesterol medication made by Pfizer, and Plavix, a top drug for coronary artery disease made by Bristol-Myers Squibb, are among those with expiring patents. And the loss of exclusivity on many of the current top sellers means a potential loss of millions of dollars of revenue for the drug makers.

How are companies preparing for the “patent cliff”?
Some companies are acquiring other drug makers or biotech firms to strengthen their business lines, expanding their own research and development efforts to design new drugs, or seeking opportunities in new markets. And most firms are cutting costs, with some having already announced staffing layoffs.

How is Putnam Global Health Care Fund positioned for this industry challenge?
We have been analyzing the variety of strategies that companies have implemented to prepare for patent expirations. In some cases, cost-cutting measures introduced as a result of the recession have meant leaner, more efficient firms, which continue to generate profits. In the long term, the drive to make acquisitions and expand business may help pharmaceutical companies become more diversified and create more stable sources of income. So, while we are aware of the risks, we believe there may be long-term investment rewards as companies adjust.

However, in the near term, the industry faces other challenges, including increasing regulation for drug approval and additional costs from health-care reform measures in the United States and from austerity measures in the EU. It is possible, too, that credit conditions for the industry may erode as companies take on more debt to finance acquisitions.

Pharmaceuticals stocks represented the largest industry sector in Putnam Global Health Care Fund for the first nine months of the year. However, the fund had an average weighting when compared with the Morningstar health funds category.* We are closely monitoring the impact of industry pressures and analyzing individual holdings based on company fundamentals.

As of September 30, 2010, Pfizer represented 7.53% of the fund, and Bristol-Myers Squibb was not held by the fund. Holdings will vary over time.

International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Additional risks may be associated with emerging-market securities, including illiquidity and volatility. The fund invests some or all of its assets in small and/or midsize companies. Such investments increase the risk of greater price fluctuations. The fund invests in fewer issuers or concentrates its investments by region or sector, and involves more risk than a fund that invests more broadly. The use of derivatives involves special risks and may result in losses. A fund that engages in short sales of securities may incur losses if the securities appreciate in value and may experience higher volatility due to leverage resulting from investing the proceeds of securities sold short.

* Morningstar health funds category includes 156 funds focused on the health-care sector.