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Although rising health-care costs are taking a bigger bite out of employers' profits and workers' paychecks, health-care stocks have been languishing for years. Operating earnings for Standard & Poor's health-care sector have grown close to 12% annually over the past three years, yet the stocks on average have climbed only 10% a year. That's a curious disconnect. Once investors connect the dots, health-care stocks should, well, get healthy.
Health-care companies have no shortage of concerns hanging over their heads. There have been high-profile product recalls (think Vioxx), and the Food and Drug Administration has become more cautious about approving new treatments. In addition, Congress is under pressure to rein in costs by squeezing providers of medical products and services. Health care will be front and center in next year's presidential race, and uncertainty will hang over the industry at least until then.
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Still, populations in most developed nations are getting older and will be spending more on health care. U.S. health-care spending, now $2 trillion a year, is expected to double by 2016 and account for nearly $1 of every $5 in goods and services that the U.S. produces. What's more, the health-care sector tends to be recession-resistant and so is particularly timely now that the U.S. economy seems on the verge of a slowdown.
And the stocks are generally cheap. On average, they trade at 15 times expected 2008 earnings, according to S&P, which expects those earnings to grow 12% next year. "Bottom line, the industry has a lot of things working in its favor," says Scott Thoma, a health-care analyst with Edward Jones. Let's take a closer look at where the best opportunities lie.
The case for pharma
Large drug manufacturers face a wave of expiring patents on their most profitable products over the next few years and are perceived as having done a poor job of developing new cash cows. But Laurent Payer, an analyst at Sectoral Asset Management, in Montreal, says the number of products in Phase II of the FDA's three-phase drug-approval process doubled between 1995 and 2005, and Big Pharma's ability to deal with patent expirations is improving. Meanwhile, these companies have been reducing costs, boosting their biotech-drug portfolios and continuing to generate a lot of cash, with which they are paying generous dividends (yields average 2%). "Over the past seven years, the companies have done a lot in terms of restructuring and repositioning that's not yet recognized by the market," says Payer. Analysts recommend focusing on companies with diversified sources of revenue so a setback in a single drug wonUt bring down the house.
A good example is Abbott Laboratories (symbol ABT). It boasts a blockbuster rheumatoid-arthritis drug, Humira, as well as drugs for HIV and obesity, a drug-coated coronary stent (which props open blocked arteries) nearing FDA approval, and strong sales of infant formula and other nutritional products. But the big story is Humira. Its sales grew 50% during the second quarter compared with the same period of 2006 and should approach $3 billion this year. The FDA has also approved Humira for treatment of two other arthritic conditions and Crohn's disease, a digestive disorder. Approvals to use the drug for other ailments, such as psoriasis, could lift sales even more. And the patent for Humira doesn't expire until 2016.
One of Payer's favorite drug makers is Wyeth (WYE). It recently suffered setbacks in clinical trials for Pristiq, an antidepressant, and bifeprunox, a treatment for schizophrenia, and the company lost a court battle to fend off generic competition for its heartburn drug, Protonix. In mid October, the shares were down 26% from their 52-week high. Now, Payer says, the shares trade solely on the value of the firmUs increasing biotech portfolio, which brings in revenues of $5 billion annually. By his estimation, investors are essentially getting the rest of Wyeth's businesses almost free -- including its pharmaceutical, consumer (Advil, Robitussin) and animal-health products, with combined annual revenues of $16 billion.
Frank Sustersic, a manager of Turner Investment Partners who helps run Touchstone Healthcare and Biotechnology fund, likes British drug maker Shire (SHPGY). It makes Adderall XR, a serious challenger to Novartis's Ritalin for treatment of attention deficit hyperactivity disorder. Diagnosis of ADHD, once regarded as a children's ailment, has been increasing in adults. Plus, European doctors' skepticism of the legitimacy of the ADHD diagnosis has waned. Patent protection for Adderall XR expires in 2009, but a successor, Vyvanse, is already in place. In addition, Shire recently launched promising treatments for Hunter Syndrome (a rare metabolic disorder) and ulcerative colitis, a chronic digestive problem.
Best of biotech
Biotechnology companies are now generating the kind of growth and excitement once associated with big drug makers. But biotech firms have been held back recently by some of the same factors hampering Big PharmaQnamely, a more deliberate FDA screening process and a paucity of new products. However, says analyst Andrew Fein, of investment bank Collins Stewart, the number of Phase III trials -- the final hurdle a new drug must clear before it hits the marketQshould pick up in 2008 and create some excitement in the sector.
Investors should tread carefully here. Because only a handful of drugs under development ever make it to market, it's best to own a group of stocks in the sector or stick with larger, diversified companies.
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