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Drug Stocks Finally Make Their Move

Story corrected to show Auxier Asset Management has $476 million in assets under management.

BOSTON (TheStreet) -- Drug stocks such as Johnson & Johnson (JNJ) and Gilead Sciences (GILD) have been beaten up in the year since the health-care reform bill was passed. That may soon change, as fund managers are pouncing on shares of undervalued companies.

Over the past year, the S&P 500 Index has climbed 13%, while the Health Care Select Sector SPDR (XLV), which counts Johnson & Johnson and Pfizer (PFE) among its top holdings, has risen only 2.5%.

The health-care reform bill, signed into law on March 23, 2010, is mostly to blame for the decline in health-care stocks. With uncertainty looming over provisions in the Patient Protection and Affordable Care Act slated to become effective each year through 2015, related stocks have been brutalized by investors put off by the increased risk. WellCare Health Plans (WCG), for instance, tumbled more than 20% last year while the broader market was up about 15%.

Many of the stocks, though, are beginning to be bid up by investors, thanks to attractive valuations. Pfizer shares have rallied more than 15% this year, easily outpacing the 4% gain in the S&P 500. Even so, fund managers with a focus on value over growth expect bigger returns from many of such companies.

"Health care is very out of favor. It's a pretty contrarian investment these days," says Connor Browne, co-manager of the $4.9 billion Thornburg Value Fund (TVAFX). "The market is skeptical and is assuming that long-term growth for the space is much lower than it had thought before. While some of this is warranted, the conclusions that the market is drawing are much too extreme."

Jeff Auxier, president of Auxier Asset Management and manager of the Auxier Focus Fund (AUXFX), says he prefers to buy stocks when the news headlines are horrible.

"With a lot of the fears of the unknown, health-care stocks dropped to bargain-price levels given that they're strong global franchises," Auxier says. "A lot of the industry leaders have sold off but historically they've traded at multiples that are at least 30% to 40% higher. There is still relatively good value."

The health-care reform overhang has been problematic for the sector because of implementation times. The so-called "bad" pieces of the legislation, which include increased taxes on medical devices, have been enacted earlier than some of the positive benefits of the reform package, such as increased-coverage benefits that aren't scheduled to become effective until 2013.

In addition to suffering from the uncertainty over reform, many companies have struggled due to high employment, as fewer doctors' visits have meant lower revenue. Companies have reported a change in mix from private payers to state payers, like Medicaid and Medicare. Browne argues that health-care stocks become a strong play on employment gains.

"As the economy recovers, unemployment continues to slide and more patients are covered by managed-care plans, so we'll start to see revenue growth kick in and it will fall to the bottom line," Browne says. "I don't think the market is expecting that from most health-care companies."

Not all health-care stocks offer the same value to investors, though. Browne and Auxier, as well as Thornburg Investment equity analyst Matthew Burdett, offer their health-care equity picks, detailed on the following pages.

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