Pharma's-Third-ActAs the curtain rises on the drug industry's latest act, the scene is ominous. Executives must choose a strategic course in the face of shifting industry economics. This will not be easy.

Revenues are declining as the blockbuster drugs that have driven growth reach the end of their life-cycles, and R&D departments haven't produced enough new products to replace the fading blockbusters. When new drugs do make it out of the clinic, they face increasingly stringent regulatory review. All this threatens to permanently erode profits.

For pharma executives, the question is, do they continue to invest heavily in research despite the recent slump in productivity? If so, should they reinvigorate their internal research departments, or do they pursue acquisitions and partnerships?

The first of the two prior acts, which began in the mid-1990s, was a happy one. A wave of products to treat conditions such as depression, high cholesterol and schizophrenia hit the market. They were cheap to make, easy to market and most importantly, largely maintenance medications – consumers took them every day, for life.

Between the end of 1994 and the end of 2000, the Dow Jones World Pharmaceutical index rose almost 2.5 times, trouncing the S&P 500 index, which rose 1.9 times.

The second act was gloomy. Eli Lilly's (LLY) Prozac and Schering-Plough's (SGP) Claritin lost exclusivity in the early 2000s, and investor attention turned to the even bigger patent expirations on the horizon: Lipitor, Zyprexa, Plavix, Diovan and their peers would not live forever. It became apparent that by the middle of the new century's second decade, the party would be over.

Things got worse. Safety issues, notably with Merck's (MRK) Vioxx and GlaxoSmithKline's (GSK) Avandia, led to product withdrawals or sales declines. Companies spent billions developing drugs, like Sanofi-Aventis's (SNY) obesity treatment rimonabant, which U.S. regulators refused to approve because of side effects.

The generic-drug manufacturers smelled blood and began aggressively challenging patents. Merck's multi-billion-dollar drug Fosamax, for example, lost years of patent protection when the U.S. drug giant lost a court decision to Israel's Teva Pharmaceutical (TEVA) in 2005. As the curtain fell on the second act, a new U.S. administration signaled its determination to cut health- care costs.

With the Pharma index down by nearly half from its peak, what direction must the industry take in the third act? At least one option should be discarded at the outset: diversification.

In discussing the acquisition of Wyeth (WYE), Pfizer (PFE) CEO Jeff Kindler emphasized how the tie-up would create a leader not only in pharma-biotech, but also animal health, consumer health and nutritional. Similarly, Merck CEO Richard Clark noted that the Schering-Plough acquisition brings with it leading nutritionals and animal-health businesses.

Part of the appeal for diversifying in this way may be that stocks of diversified firms, such as Johnson & Johnson (JNJ), have shown more resilience in the recent downturn than pure-play pharmas. Rightly or wrongly, consistent and predictable earnings get a premium during a crisis.

But investors can diversify by simply buying stocks from different sectors or owning exchange-traded funds. There's little need for diversification within a single company. What investors need instead are companies with competitive advantages, adequate capitalization and the ability to execute.

To be sure, diversification makes sense for companies with assets that can be leveraged, at low incremental cost, into new product lines. This is true for small-molecule pharmaceuticals and biologic drugs or generics, where there is overlap in scientific, marketing and regulatory expertise. But medical devices? Over-the-counter remedies? Baby food? It is hard to see what these provide besides smooth cash flows.

Pharma executives and their advisors in the capital markets should understand: diversifying into areas where there is not true operational leverage with the drug business is nothing but taking cash generated by the drugs and investing in an unrelated area. If that is the best available course, return the capital to investors and let them make their own reinvestment choices.

One Big Pharma chief executive grasps this point: Bristol-Myers Squibb (BMY) CEO James Cornelius.

"We couldn't be a mini-J&J" he was quoted as saying in The Wall Street Journal.

He's right. Bristol has recently sold or spun off several non-drug businesses. It sold its medical-imaging business in December 2007 for $525 million to Avista Capital Partners. Its wound care business went to Avista and Nordic Capital in August of 2008, for $4.1 billion. Most recently, it spun off 17% of its Mead Johnson (MJN) infant nutritionals business in a stock offering that raised nearly $800 million.

The company now has a $1.5 billion net cash position, before the proceeds of the Mead Johnson spin-off, and plans to pursue a strategy of acquisitions and partnerships to rebuild its pipeline. There is no shortage of places for them to invest – there are roughly 500 pharma and biotech firms with market values under a billion dollars, not to mention all the privately held companies across the world. The economic climate will make many of these eager for a partner with deep pockets.

Bristol is building a drug company that focuses on selling drugs. Perhaps that is why the stock has outperformed most of its peers over the last year.

This is not to say the drugs that Bristol purchases will ultimately succeed. Science, which will play a decisive role, is impossible to predict. And it may be that those companies that invest internally will be more productive than those that acquire and partner. But at least Cornelius is not hiding from the long-term issues the industry faces.