Best Bets in Health Care Stocks

Despite the slow growth most economists see ahead, the health care sector should keep booming. Consumers may cut back on purchases of cars or washing machines in tough times, but they’re not going to skimp on their own health. Current valuations are breathtakingly low; you can buy some of the best health-care companies in the world at price-earnings ratios in single digits.

Americans now spend a little more than one of every six dollars to purchase health care. According to the Congressional Budget Office, that spending will rise to about one in three dollars by 2035. This demand will fuel more investment in new health-care technology, which, in turn, will lead to better medicines and devices, such as improved artificial hips and hearts.

Certainly, money is wasted -- that’s what you might expect in a system in which, by 2082, federal and state agencies will be paying an astonishing 49% of the tab. Overall, however, we spend more on health care because we want therapies that reduce heart attacks and turn cancers into chronic, rather than fatal, diseases.

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The Centers for Medicare and Medicaid Services projects that health spending will rise 5.8% a year, on average, for the next decade. That’s a rate of growth that most investors, in this age of reduced expectations, would find attractive. But health care is an enormous industry, and some subsectors will do much better than others. Here’s a rundown:

Big Pharma

Of the $2.5 trillion Americans spent on their health in 2009 (the most recent year for which these figures are available), $250 billion went to buying prescription medicines. The profits can be prodigious. In 2002, Pfizer (symbol PFE) earned $9.5 billion on $32.4 billion in sales, and the company’s return on equity, a measure of profitability, was an eye-popping 48% (stocks in boldface are those I recommend). But the risks are big, too. The business model for the large drug companies has come to resemble that of giant movie studios: Invest heavily in hopes of a blockbuster, and realize that much of your research and development will produce nothing at all.

Merck (MRK), for example, spent $11 billion last year on R&D, or about one-fourth of its total sales. Because it is protected by a patent wall, a drug such as Lipitor, Pfizer’s cholesterol reducer, can score huge sales -- $11 billion globally last year, or about 16% of the company’s revenues. But patents expire, inviting competition from makers of generic drugs, which drives down both prices and revenues. That’s the problem this year and next -- not just for Pfizer but for Bristol-Myers Squibb (BMY), with its blood-clot-preventer Plavix; Merck, with its asthma drug Singulair; and for many other major pharmaceutical makers. The solution? Invest more in building up a pipeline of new drugs, cut costs, buy up other firms, or, in the case of Pfizer, persuade the Food and Drug Administration to approve the sale of drugs over-the-counter, without a prescription.

The drug giants face real challenges, but their share prices already reflect the problems and then some. As of August 8, Pfizer and Merck carry P/Es, based on estimated earnings for 2011, of just 7 and 8, respectively; the P/Es of Eli Lilly (LLY) and Swiss-based Novartis (NVS) are 8 and 10, respectively.

These companies are all solid citizens. They make products that will keep selling even in a sluggish economy, and they’re benefiting especially from growing wealth in developing countries. Pfizer, for instance, is sitting on $28 billion in cash, is rated A+ for financial strength by Value Line, and offers a dividend yield of 4.6% -- compared with a 2.4% yield on a ten-year Treasury bond.

Biotechnology

This is a subsector dominated by a single company, Amgen (AMGN), with a market capitalization (stock price times shares outstanding) of $48 billion. Amgen’s sales have been flat for four years, its pipeline of new drugs uninspiring. But it’s rolling in cash, continues to make hefty profits, and carries a P/E of 10. In second position is Gilead Sciences (GILD), a longtime favorite of mine, with a market cap of $29 billion. Gilead, which makes drugs to combat AIDS, high blood pressure and angina, among other ailments, trades at just 9 times earnings.

Nearly all the other biotechs depend on the success of only a few drugs (sometimes just one) and often have shaky balance sheets. One such unfortunate example is Human Genome Sciences (HGSI), which soared to $116 a share in 2000 on excitement over the value of gene-sequencing discoveries to finding new drugs. Since then, the company has lost money every year, and its stock reached 50 cents in 2009. It has bounced back sharply, however, and the approval of a single drug, Benlysta, for lupus, could be the firm’s salvation.

Medical Devices

Innovation has moved especially swiftly in the device subsector, perhaps because federal regulators are a tad easier on device makers than on drug companies. Kris Jenner runs T. Rowe Price Health Sciences (PRHSX), the best of the broad-based health funds, with a modest expense ratio of 0.84% a year and an annualized return of 7.5% for the past ten years through August 5 (an average of 5.7 points per year higher than Standard & Poor’s 500-stock index). Among Jenner’s ten biggest holdings is Stryker (SYK), which makes a wide range of products, from surgical power drills to joint replacements. The company is solidly profitable, has an excellent balance sheet and sells for 13 times estimated profits.

Pharmacy Benefits Services

The shape of this subsector, which handles drug benefits for insured patients, has changed drastically in recent years. In July, Express Scripts (ESRX), with $45 billion in revenues last year, announced it was buying the larger Medco Health Solutions (MHS), with $66 billion in sales. The resulting firm will service one-third of all Americans. In 2007, CVS, the drug chain, merged with pharmacy benefits servicer Caremark to form a company, CVS Caremark (CVS), whose sales will top $100 billion this year. A better bet than both may be a specialist, such as Omnicare (OCR), which focuses on serving seniors at long-term-care facilities; its P/E is 12. A similar play is PharMerica (PMC), a provider to hospitals, with a P/E of 13.

Diagnostics

Two companies dominate the clinical lab business, and both have done well in a bad economy. After all, people get their blood and urine analyzed whether they’re sick or healthy. Quest Diagnostics (DGX) has increased its earnings at an average rate of 26.5% over the past decade; it trades at a reasonable 12 times earnings. Profits at Laboratory Corp. of America (LH), a bit smaller, have climbed at a rate of 30% over the past ten years.

Health Insurers

How will the big insurers fare under health-care reform? Awfully well, judging by what their stock prices have done since the law’s passage. UnitedHealth Group (UNH) is a particularly well-managed company that’s been increasing its revenues impressively. Shares of Aetna (AET) have returned 28% over the past year through August 5 and an incredible 19.1% annualized over the past decade. Both stocks trade at enticing prices: 10 times earnings for UnitedHealth, 7 for Aetna.

Investors can choose from a number of superb health sector funds. In addition to T. Rowe Price Health Sciences, consider Vanguard Health Care Investors (VGHCX), with an expense ratio of just 0.35%, and Fidelity Select Health Care (FSPHX), whose holdings include more-aggressive companies, such as Covidien (COV), a medical-device maker. In a market and an economy facing uncertainty and turmoil, many health stocks -- despite their vulnerability to changes in government policy -- can serve as safe havens in a storm.

James K. Glassman, executive director of the George W. Bush Institute, is the author, most recently, of Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence (Crown Business).