Health Care Stocks for a Weak Economy

Health care is a classic defensive sector. No matter how bad the economy is, the argument goes, people still get sick. And they'll pay for medical care before they'll pay for almost anything else.

So far, health care stocks are holding up better than the rest of the market. Through January 25, the Morningstar health care sector is down less than 4% -- making it the best performing of ten broad market sectors.

Nonetheless, health care stocks could use some healing. For major pharmaceutical companies and small biotech firms alike, this decade has been awful. On average, stocks in both industries have declined roughly 25%.

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Onetime glamor stocks, such as Pfizer (symbol PFE), now trade at just ten times the previous 12 months' earnings. It's easy to diagnose the problem. Pharmaceutical and biotech companies have failed to produce many of the breakthroughs that were anticipated with the mapping of the human genome. Meanwhile, plenty of blockbuster drugs have lost patent protection, and many more will go generic in coming years, particularly in 2011 and 2012.

"People thought the world would change sooner and at less cost than has actually happened," says Sam Isaly, one of the nation's savviest and most experienced drug analysts and manager of Eaton Worldwide Health Sciences fund (ETHSX).

Isaly himself recalls forecasting in 2000 that the number of major drugs approved by the Food & Drug Administration each year would double, to 60, by the end of this decade. Instead, the FDA approved just 19 drugs last year. "The pace of innovation was not as anticipated," he says.

The FDA has been slower to approve new drugs. Moreover, analysts fear that if the Democrats sweep the elections in November, they'll ultimately limit price increases on medications. The bottom line of all this: "Companies will have to shrink their sizes," Isaly says. "There will be a lot of blood in the water."

Isaly, however, remains an optimist -- he just thinks he was early. Numerous biotech medications are in late-stage clinical trials. Already, new cancer drugs are being rolled out, and other important drugs are on the way.

Among Isaly's favorite stocks:

Gen-Probe (GPRO) is a leader in molecular diagnostics. It has tests for HIV and Hepatitis B and C, and is developing a more-reliable prostate cancer screening test. "Earnings will grow 20% annually as far as the eye can see," he predicts. The stock closed at $56 on January 25.

Schering-Plough (SGP) brought down the whole drug sector this month when it announced results of a widely heralded trial called Enhance. The study found that Vyotrin, a combination of Merck's Zocor and Schering's Zetia, worked no better than Zocor alone at removing plaque from arteries.

Isaly doesn't believe the study is the end of the story. Plus, Schering, which closed at $19 January 25, looks cheap, with the stock off nearly 40% since early December. The company has other promising drugs and no major patent expiration problems.

Vertex Pharmaceuticals (VRTX) has a potential blockbuster for the treatment of Hepatitis C, a sometimes fatal disease. Isaly says the drug will win approval around 2010 and ultimately generate billions of dollars in sales. It closed at $19.

The Eaton Vance fund is a fine one, but it carries a sales charge. T. Rowe Price Health Sciences (PRHSX) is probably a better choice. The Price fund has held up surprisingly well during the long dry spell thanks to topnotch stock picking by manager Kris Jenner, a Johns Hopkins-educated physician with a decade of experience studying medical stocks.

Over the past five years, the fund has returned an annualized 17%. That's an average of six percentage points per year better than Standard & Poor's 500-stock index and more than twice the return of the Morningstar Healthcare index.

Jenner says he doesn't see any compelling health care subsectors. He's been helped in recent years by his ownership of managed-care companies, in addition to drug, biotech and medical device firms.

Like Isaly, he says biotechnology will pay off in a huge way, but he's less certain about how soon that will be. "We're in a period where there are reasons to believe, but you'd like to see evidence of it," he says. "I don't think we've disproved the premise, but clearly the timelines are much longer than people thought."

Jenner is especially optimistic about medications for Alzheimer's. Irish-drug maker Elan (ELN), $23, is currently in clinical trials with a drug that he thinks has better than a 50-50 chance of making a major contribution to Alzheimer's treatment. If the drug makes it to market, "this company will have explosive growth over many years," says Jenner.

Another pick is Alexion Pharmaceuticals (ALXN), $64, which has won FDA approval for "a remarkably effective drug" for treating a rare genetic blood disorder. Jenner says the company will turn profitable this year.

Onyx Pharmaceuticals (ONXX) has a newly approved drug for liver cancer. Like Alexion, it should become profitable this year, he says. It closed at $47.

I've always liked pharmaceuticals and biotech mainly because of the patent protection on new drugs. Jenner's fund is the pick of the no loads -- and a great choice in a weak economy. Just don't go overboard. Don't make it more than 5% of your stock investments. After all, your diversified stock funds invest in health care, too.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.