Nellie S. Huang, Senior Associate Editor,
Kiplinger's Personal Finance • July 3, 2019
Health
care stocks cover a lot of bases. They're defensive because people always need
medicine and medical care. They're fast-growing because innovative treatments
are powering profits at several drug companies. And now, they're cheap,
too.
Scrutiny
of the health care system is high, thanks in part to the upcoming 2020
presidential election, and that has weighed on the sector's stocks. From talk
of Medicare for All to legal challenges to the Affordable Care Act to proposed
drug-price regulations, "there's a lot of political noise," says
Baron Health fund manager Neal Kaufman. As a result, shares in many good
companies that were once expensive are now a bargain. "This is a great
opportunity to buy stocks that are being punished unnecessarily," Kaufman
says.
Few
industry watchers believe Medicare will be nationalized. What will happen with
the ACA or drug pricing is harder to predict. Even so, some pockets of the
health care sector face greater uncertainty as the debate continues. Hospitals
and businesses focused solely on insurance, for instance, would be at risk in a
single-payer system.
But an
aging population and the breakneck pace of drug innovation bode well for other
parts of the sector over the long term. The Food and Drug Administration approved
more new drugs in 2018 than in any year before. Just as the internet disrupted
multiple industries, including tech and retail, "health care is on the
verge of initiating significant change," says Gary Robinson, manager of
Baillie Gifford American fund, a U.S. stock fund for U.K. investors.
To cash
in on these long-term trends, we scoured the sector and found eight good
opportunities. The stocks we like fall into three broad health care areas:
drugmakers, health care service providers, and medical device and equipment
manufacturers. Their share prices may continue to bounce around, especially as
we near the 2020 elections. Smart investors will buy more when shares dip.
"If you have flexibility and you can pick your spots, you can make money,"
says Matt Benkendorf, chief investment officer at money management firm
Vontobel Quality Growth. (All returns and data are through June 14.)
Drugmakers
Half of
all health care stocks in the U.S. are drugmakers. They include big
pharmaceutical firms and older biotechnology companies that are steady growers
and pay dividends, as well as smaller, faster-growing biotech firms with one or
two products on the market and riskier outfits with no commercial products yet.
The
lines are starting to blur as the traditional pharma firms, which combine
chemicals to make drugs, and the biotech companies, which tap organic elements
such as cells to create therapies, are coming together through mergers,
acquisitions and partnerships to cash in on drug innovation. Gene sequencing
and other advancements have changed the way we treat cancer, congenital
diseases and other ailments, and "the level of innovation is
accelerating," says Damien Conover, Morningstar's director of health care
stock research.
Figuring
out which companies will thrive, however, can be tricky. A good drug company
has two key attributes: a stable of drugs with patent-expiration dates that are
years away, and a fat pipeline of new drugs nearing FDA approval. But drugs and
the diseases they treat are complicated. And success often breeds stiff
competition. "Behind a lot of blockbusters are a lot of fast followers,"
says Jim Golan, comanager of William Blair Large Cap Growth fund.
It
doesn't help that drug prices are under a microscope. Thanks in part to the
current administration's efforts to lower the price Medicare customers pay for
some drugs, "the pricing power of pharma firms has been stopped,"
says Edward Yoon, manager of Fidelity Select Health Care Portfolio. That's one
reason Yoon, among others, eschews big pharma in his fund. Still, big
drugmakers with a slew of products will weather changes in pricing and reimbursement
better than companies with thin product lines. Smaller outfits that offer
life-transforming drugs for rare diseases may also come through with less
damage.
Merck
(symbol MRK, price $83) is an
elder statesman in the pharma world that should continue to thrive in the new
order. Keytruda, Merck's immunotherapy drug that basically gets the immune
system to kill cancer cells, is "rapidly becoming one of the largest
products we've ever seen," says JPMorgan Chase analyst Christopher Thomas
Schott. The drug is currently approved to treat 11 types of tumors, including
advanced non-small-cell lung cancer and melanoma.
In the
drug world, a medicine is a blockbuster if it surpasses $1 billion in annual
sales. Last year, Keytruda hit $7 billion. Morningstar expects it to reach $16
billion in 2022. And that number could rise. Scientists are testing Keytruda,
alone and in combination with other therapies, for dozens of diseases in more
than 1,000 studies. And Merck has time to cash in. The oldest patent on
Keytruda doesn't expire until 2028.
Merck
also makes vaccines that are big cash generators and are less subject to drug-pricing
pressures. In 2018, sales of Gardasil, the cervical cancer vaccine, jumped 37%
from the year before to hit $3.2 billion. The firm also has an animal health
unit, which doesn't suffer from the regulatory uncertainty that vexes the human
side of the business. The pet and livestock business represents only 10% of the
company's overall operations, but it's growing faster than Merck's drug unit.
Merck
shares trade at 16 times estimated 2020 earnings--a premium to shares of its
large-company pharmaceutical peers, which trade at an average of 14 times 2020
earnings. But Merck is growing faster. Over the next three years, analysts
expect earnings to increase 8.9% per year, on average, which is better than the
8.2% rate of other large pharma firms.
Biotech
company Vertex Pharmaceuticals (VRTX, $170) has a lock
on treatments for cystic fibrosis, or CF, a rare lung disease caused by a gene
mutation. The company's drugs are transformational. CF treatment was once
limited to alleviating the symptoms of the disease. But Vertex's therapies
treat the underlying cause of the disease by trying to allay the gene mutation.
Of the estimated 75,000 CF cases worldwide, Vertex makes three drugs that treat
34,000 cases.
Its
reach is expanding. The company has a new drug referred to as the "triple
combination," which is expected to win approval in the U.S. in 2020 and
could nearly double the number of CF cases Vertex treats, says CFRA analyst
Kevin Huang. "With the likely approval of the triple, Vertex would cement
its dominant position as the only real player in developing targeted therapy
for CF," says Credit Suisse analyst Evan Seigerman.
In the
meantime, the business is healthy. Vertex has $3.2 billion in cash and little
debt. Analysts expect Vertex earnings to increase an average of 22.5% per year
over the next three years, way ahead of the average 17.8% growth rate for its
peer group, biomedical-genetics drug companies.
A
smaller biotech firm with no profits--yet--fills out our drugmaker favorites.
Neurocrine Biosciences (NBIX, $84) is expected
to be profitable in 2020. It has two drugs on the market and a strong pipeline
of therapies in all stages of development. One of its commercial drugs,
Ingrezza, is a "best in class" therapy for tardive dyskinesia, a
condition that causes jerky, involuntary face and body movements, says Credit
Suisse's Seigerman. He thinks it could fetch annual sales of $2 billion by the
early 2020s.
Neurocrine
also has Orilissa, a drug for endometriosis pain, which Seigerman believes
could be a market leader. Neurocrine won't rake in every dollar made on
Orilissa sales, because the firm partnered with AbbVie to market the drug, but
it will earn a meaningful royalty. Neurocrine is Seigerman's top pick in the small
and midcap biotech category. He expects strong revenue growth of 31% annualized
over each of the next five years.
Health care services
We're
in the early days of a revolution that could one day lower overall health care
costs for everyone. In today's health care system, a doctor and a hospital are
most often paid to treat a patient who already suffers from an illness. In the
future, prevention and continuing care--some call it holistic care--will take
precedence.
The new
health care model will only work if every p in the system--patients, providers
(doctors, hospitals) and payers (insurers)--work together to make good
decisions early, so healthy patients can stay well, and out of the hospital,
longer. A healthier population, the theory goes, will lead to fewer dollars
overall spent on health care.
It's
happening already in a handful of U.S. cities, including Austin, Denver, and
parts of Ohio and Florida, says Yoon. In those areas, hospital admission rates
and emergency room visits per 1,000 people (industry measures of the quality of
care) have dropped significantly due to the alignment of the p's. Costs have
come down, too, he adds. But it could be a generation before we see change on a
national level. "What works in Texas may not work in New York. My expectation
is that it will happen eventually, but it will take longer than anyone
wants," says Yoon.
UnitedHealth
Group (UNH, $245) stands at the
center of this long-term trend. UnitedHealth has a stake in every p. Being the
biggest health insurer in the country makes it a payer. It's a provider through
its OptumHealth division, which offers medical services at urgent-care clinics
and walk-in surgical-care centers. And its 50 million insured members are
patients. UnitedHealth is essentially a microcosm of the country's health
system.
OptumInsight
is UnitedHealth's secret weapon. The business unit collects and analyzes
treatment data that can be used to improve health care outcomes, thus lowering
medical bills. "You call your insurer," says Andrew Adams, lead
manager of Mairs & Power Growth fund, "and they'll have your entire
medical history. Based on records from doctors, drug prescriptions and hospital
records, they'll know the best course of action to deliver care to you more
efficiently." At least, that's the idea.
CVS
Health (CVS, $54) aims to give
UnitedHealth a run for its money. It's best known for its drugstores--70% of
people in the U.S. live within three miles of a CVS pharmacy--but it operates
more than 1,000 walk-in clinics, too. With its acquisition of Aetna in late
2018, CVS is now also an insurer.
Both
stocks are bargains. UNH shares trade at 16 times estimated earnings, a level
not seen since 2014 and a rare discount for these premium shares.
"UnitedHealth has always been expensive," says Mairs & Power's
Adams, who loaded up on more shares when the stock sold off in early 2019.
Analysts expect 12.7% annualized earnings growth over the next three years.
CVS
took on debt to acquire Aetna for $70 billion, and consequently it did not
raise its dividend in 2018, ending a 14-year record of consecutive annual
increases. The integration of Aetna and the debt paydown will take time, says
CFRA's Huang. (The completed merger has been challenged in court, but Huang
expects the deal to remain mostly intact.) He rates the stock a "strong
buy," in part because at the current price, it's a bargain. It trades near
its 52-week low, sporting a 3.7% yield, and has a price-earnings ratio of
8--more than 40% below the stock's median historical P/E of the past 10 years.
Meanwhile, earnings are expected to increase by an annualized 7.2% over each of
the next three years.
Medical devices
Drugmakers
are spending gobs of money to research and develop innovative therapies. Life
sciences tool companies--a subset of the medical-devices industry--make
"the picks and shovels" that enable that effort, says Jason Kritzer,
comanager of Eaton Vance Worldwide Health Sciences fund. Analysts expect
companies in this group to increase earnings over the next three years at a
rate of 12% to 14% per year, on average, compared with 10% for companies in
Standard & Poor's 500-stock index.
Size
helps in the medical device world. A lack of funding has, in part, made it
difficult for small device companies to survive on their own, and most are
acquired by large companies. Accordingly, our favorites have heft in their
favor.
Thermo
Fisher Scientific (TMO, $285) is a big
kahuna in the life sciences industry. Record spending on biotech-drug research
is fueling demand for the company's lab products and services, gene-sequencing
instruments, analytical tools, and diagnostic kits. More than 80% of its
revenue is tied to recurring sales of its consumable products (syringes,
diagnostic tests and other single-use items) and services, says Chris Smith,
manager of Artisan Thematic fund. That makes the company less vulnerable to
economic swings, says Smith. Meanwhile, Thermo leads the sector in sales and
earnings growth that is internally driven (and not attributable to
acquisitions, say). Moreover, he adds, "we think TMO has the best
management in the industry."
Analysts
expect 12.5% profit growth annualized over the next three years. The stock
trades at 23 times estimated earnings, compared with an average multiple of 36
for its peers in the medical instruments market.
After
spinning off its drug division in 2013, Abbott Laboratories (ABT, $82) now focuses on
a diverse roster of products that includes nutritional drinks, diagnostics,
generic drugs and medical devices. But a trio of new products put it in the
sweet spot of the health care sector's innovation surge, says William Blair's
Golan.
One is
FreeStyle Libre, a 14-day wearable continuous glucose monitor that does away
with finger pricks and tracks patterns and trends over time, helping patients
manage their diabetes better. Another is MitraClip, a device that allows
patients with a certain heart condition to get treatment with less-invasive
surgery (in other words, not open-heart surgery). It has no competition, says
William Blair analyst Margaret Kaczor, and a recent FDA decision doubles the
number of eligible patients for the device. The third of the trio, Alinity, is
a next-generation diagnostic system that integrates and streamlines the
workflow of a diagnostic lab, using analytics and automation to standardize
research processes, reduce costs and manage labor constraints.
Abbott
proves that even giant companies can be innovative. More than 50% of the firm's
sales come from products that launched within the past six years. Analysts
expect annualized profit growth of 12.3% over each of the next three years.
Intuitive
Surgical (ISRG, $497) is a leader
in minimally invasive, robot-assisted surgery. Surgeons perform
operations--urological and gynecological procedures, among others--using the
company's technically advanced instruments and 3D, high-definition vision
capability known as the da Vinci system. "This market is in its
infancy," says Samantha Pandolfi, a comanager of Eaton Vance Worldwide
Health Sciences. Of the 60 million general surgical procedures performed
worldwide last year, almost a million were conducted with the da Vinci system.
"There's a long runway for growth, and the company's lead over the
competition is wide," she says. "We think it can sustain double-digit
sales and earnings growth for a very long time." Analysts, according to
Zacks Research, expect 12.2% earnings growth, on average, over each of the next
three years.
Invest with a specialist
The
outcomes for small, go-go biotech firms can be extreme--you either win big or
you lose everything--and the work they do is complex. You might appreciate a
fund with an expert at the helm who has the experience and resources to
understand and weigh the risks.
Ed Yoon
has been analyzing health care companies for over a decade, and has run
Fidelity Select Health Care Portfolio (FSPHX) since 2008. The
fund has delivered above-average returns with below-average volatility under
Yoon; its 10-year, 18.3% annualized return beats 90% of all health care funds.
Yoon takes big stakes in steady, large companies that provide ballast for the
smaller bets he makes on burgeoning biotech firms. Biotech firms, health care
services companies (including insurers), and medical instruments and device
makers represent the biggest chunks of the fund.
As
manager of Janus Henderson Global Life Sciences (JAGLX), Andy Acker has
been researching health care companies for more than two decades (he comes from
a family of physicians, too). He spreads his investments across the sector,
keeping one-third of the portfolio in drugmakers, one-third in biotech firms,
and the rest in health care services and medical devices. Over the past 10
years, Janus's annualized return beat 78% of its peers.
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