5 Health Care Stock Picks on the Mend

Nothing can kill stock prices quite as effectively as uncertainty, and health insurers and health maintenance organizations have been living in the swirl of the unknown for the past three years, thanks to the Patient Protection and Affordable Care Act. But now that the Supreme Court is weighing the constitutionality of a key element of the law, there are fewer remaining questions about the impact of the controversial legislation, and industry insiders are increasingly convinced that the prognosis of an industry "death spiral" was premature.

In fact, analysts believe that the Supreme Court's decision -- no matter what it is -- is likely to revive health care stocks, which are already showing signs of new life. "The market is anticipating a favorable outcome," says Chris Rigg, an analyst at Susquehanna Financial Group in New York City.

Why? There's growing sentiment that the Supreme Court won't throw out just one piece of the law, without kicking other pieces of the legislation to the curb as well. The only outcome that investors couldn't abide was eliminating so-called insurance "mandates," while leaving the rest of the law in place.

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Health Insurance and the New Law

Understanding why that scenario had experts trembling about a death spiral demands a short primer on both health insurance and the new law. Insurers -- and health maintenance companies, which offer in-network medical care for a set monthly stipend -- encourage large numbers of people to pay relatively small amounts every year to protect against the slight chance that they'll face a catastrophic ailment. By collecting, say, $1,000 from 100,000 people, the insurance company would be able to pay $100,000 in medical bills for the 900 hapless patients that its statistical analyses say are likely to get seriously ill in any given year, and the insurer could still post a profit.

If, however, few healthy people are willing to pay premiums, the cost of providing coverage to the sick becomes unbearable. If just 10,000 people bought insurance, they'd each have to pay $10,000 to get the same $100 million pool. If a higher percentage of premium-payers were sick, insurers would have to hike premiums dramatically -- possibly into unaffordable territory -- or go out of business.

In the past, health insurers and HMOs could protect themselves from covering a group that was unusually likely to develop costly ailments by denying coverage to those with congenital ailments and pre-existing conditions. The health care reform law bars that, demanding that insurers take all comers, no matter how sick. The quid pro quo was that everyone would have to buy insurance, increasing the number of healthy premium-payers, too. If the mandates were to be eliminated, insurers feared that no one would buy coverage until they were sick. That would make coverage unaffordable and drive insurers and health maintenance firms out of business.

Now, however, industry insiders speculate that the Supreme Court decision, due out in June, is unlikely to only toss out the mandates. Instead, they see three possible outcomes: Either the court will uphold the law; or it will throw out several related pieces -- in other words, if the mandates are out, they'd also trash the requirement that insurance companies take all applicants, no matter how sick; or it will throw the ball back to Congress, saying that health-care reform cannot be enacted without the potentially unconstitutional piece. With the worst-case scenario appearing increasingly unlikely, analysts think some companies look cheap and could provide robust returns.

5 Healthy Stock Picks

WellPoint (symbol WLP), an Indianapolis-based managed care company, is Morningstar analyst Matthew Coffina's top pick. The stock, at $70.68, trades for 9 times estimated 2012 earnings of $7.74 per share (all prices and related data are as of April 20). One reason the stock is so cheap is that WellPoint stumbled last year by charging too little for some policies. That brought in a lot of new, but unprofitable, business. The good news, says Coffina, is that the company recognized the mistake and is already in the process of raising rates, which should boost future results.

Analyst Thomas Carroll, of Stifel Nicolaus & Co., also thinks that WellPoint may postpone some of the heavy spending necessary to gear up for health reform. That could also goose 2012 earnings beyond current estimates and fuel the stock price. Coffina thinks WellPoint should be selling for $105 -- a 49% premium over its current price. Carroll isn't quite as optimistic, but he still rates WellPoint a buy, expecting the stock to hit $85 within a year.

WellCare Health Plans (WCG) is positioned to profit from two compelling trends that are only marginally affected by the health reform law. About 60% of the Tampa, Fla.-based company's business comes from Medicare and Medicaid payments. The Medicare business is growing rapidly as the 77-million-strong baby-boomers reach an age when they become eligible for Medicare. Meanwhile, states have been pushing an increasing number of their Medicaid recipients -- those who are too poor to pay for health care on their own -- into managed care programs, which has also helped WellCare fuel double-digit growth.

Analysts expect the company's profits to rise at an annualized 18% rate over the next few years, but its stock, at $68.55, sells for just 15 times estimated 2012 earnings of $4.66 per share. Carroll thinks the stock should trade at $85 within a year.

The appreciation potential isn't quite as bright at Humana (HUM), which also benefits from an aging population, with the bulk of its profits coming from Medicare Advantage plans. These plans offer additional bells and whistles to seniors on Medicare for the price of an ordinary Medicare premium. The catch is that you have to use in-network doctors, just as you would with any other health maintenance plan. Analysts expect Humana, based in Louisville, Ky., to generate annual earnings growth of 10% over the next several years.

Medicare was left largely unscathed by health reform, and Medicaid programs appear to be growing with or without it, so Humana appears to be relatively insulated from the potential ravages of the health-care-reform law. It has a proven record of being able to put together attractive, reasonably priced Medicare Advantage plans to secure its growth, says Carroll.

At $90.00, the stock sells for 11 times estimated 2012 earnings of $7.99 per share and yields 1.1%. That's not much of a payout, but because dividends are relatively rare in this space, it adds a touch to the company's value. Admittedly, the stock was a more compelling buy last fall when the Supreme Court was considering reviewing the law and industry stock prices plunged indiscriminately. At that point, Humana sold for less than $80. If Humana were to drop back toward that price in a market correction, it would be a great time to pick up a few shares.

Kim Purvis, an analyst with Cross Current Research, a Princeton, N.J., analysis firm that specializes in health care and technology, sees modest year-ahead gains for Aetna (AET) and Cigna (CI). She thinks both can appreciate by at least high single-digit percentages, largely as the result of their modest valuations and because they're both raising prices in some segments of their businesses. At $49.21, Aetna sells for a bit less than 10 times estimated 2012 earnings of $5.15 per share and is expected to generate long-term profit growth of 11% a year. The stock yields 1.4%. Cigna, at $48.02, sells for just under 9 times estimated 2012 earnings of $5.41 per share. It's also expected to grow at a 11% clip, but it pays only a negligible dividend.

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