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Despite Ill Winds, Health Stocks Look Healthy

Health stocks have faced strong headwinds. The sluggish economy has caused patients to postpone elective surgery, while pharmaceutical companies have been hurt by healthcare reform and expirations of patents on blockbuster drugs. Should you avoid health stocks? No, said Morningstar health analyst Alex Morozov, who spoke recently at Morningstar’s ETF investment conference in Chicago. The valuations look compelling, and many companies should report solid earnings growth, he said.

During the past decade, the average price-earnings ratio for big pharmaceutical stocks was 15. But since the financial crisis softened demand for health services, the multiple has dipped to 10. Morozov argued that the multiple should recover to 12.5 as the economy revives and a new generation of drugs comes to market.

Some blue-chip stocks have been especially hard hit by patent concerns. When patents expire, blockbuster drugs are replaced by cheap generics. Blockbusters that will soon lose patent protection include AstraZeneca’s Crestor cholesterol medication and Merck’s asthma treatment Singulair. “It is unprecedented for this many products to come off patent,” said Morozov.

The problem is particularly worrisome because the U.S. Food and Drug Administration has become more cautious about approving new medications. Since Merck was forced to withdraw Vioxx from the market in 2004, the FDA has tightened its standards and granted fewer patents. “Now the review process takes longer, and drugs are rejected more frequently,” said Morozov.

While the FDA is not likely to change its philosophy any time soon, the drug companies are developing approaches that should help to boost profits, said Morningstar analyst Damien Conover. First the companies have been cutting costs, reducing marketing efforts and laying off thousands of employees. In addition, the pharmaceutical giants have altered their research efforts. Instead of developing me-too drugs that can treat common problems such as high blood pressure, the scientists are focusing on niches that have been underserved. The FDA is more likely to approve such unique therapies because they are badly needed by certain patients, said Conover. In the next several years, revenues from niche products should replace much of the sales that will be lost from patent expirations. Pharmaceutical stocks should also get a boost from growing sales in the emerging markets. While emerging markets accounted for 5% of industry sales five years ago, the figure should climb to 20% by 2015.

To participate in the industry turnaround, the Morningstar analysts recommend pharmaceutical giants, including Abbott Laboratories (ABT), Johnson & Johnson (JNJ), and Novartis (NVS). Conover said that some of the best bargains include smaller biotechnology companies, which were pummeled when the markets turned down in July and August. To own those, he suggests First Trust NYSE Arca Biotech (FBT), an ETF that holds a roughly equal weighting of 20 names. A less attractive option is iShares Nasdaq Biotechnology Index (IBB). That fund is large and liquid, but it emphasizes big stocks that are not the best bargains.

While the recession slowed the increase in healthcare spending, the growth rate should soon resume climbing. According to the Center for Medicare and Medicaid Services, healthcare spending grew at an annual rate of 3.9% in 2010, the smallest increase in five decades. Spending was slowed because the number of insured people dropped by 4% during the recession as companies laid off workers and eliminated benefits. But as the economy recovers, health expenditures should revive. The Center for Medicare and Medicaid Services says that expenditures will climb at an annual rate of 5.8% through 2020.

The slowdown in spending has hurt makers of medical devices. Unable to cover out-of-pocket expenses, patients have postponed hip and knee replacements. But Conover argued that aging patients will eventually resume paying for the procedures. “The alternative to surgery is taking a lot of painkillers or using a wheelchair,” he said.

He recommends such as device makers as Stryker (SYK) and Zimmer Holdings (ZMH). Those companies dominate their niches and have long histories of increasing profits.

While many investors have worried that health reform would hurt pharmaceutical companies, Conover said that the new legislation could have little effect on the industry’s long-term outlook. After the legislation passed in March 2010, some companies announced that their earnings for the year would be 2% to 5% lower than expected.
The decline occurred because the legislation requires pharmaceutical makers to pay fees that support the drug programs of Medicare and Medicaid. While the industry faces increased costs, those should largely be offset by the greater revenues that will be recorded when 30 million new people obtain health insurance in 2014, Conover said.

What happens if the Supreme Court strikes down the health legislation’s requirement that everyone must buy health insurance? The number of insured will not increase by much, and the legislation will hurt pharmaceutical earnings by 2% annually, said Conover. But the small earnings decline will not prevent the industry from prospering in coming years.

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