Health Funds See Value in Lagging Sector

NEW YORK (TheStreet) -- At a time when stocks have been climbing nicely, health care and drug shares have lagged. During the past 12 months, health funds returned 10.5%, trailing the S&P 500 by 10 percentage points, according to Morningstar.

A variety of factors have held back companies in the sector. Responding to the debt crisis, European national health plans hurt drug companies by demanding price cuts. In the U.S., many drug and device companies announced that their earnings would suffer because of health care reform. That was a special blow for pharmaceutical blue-chips that have long been plagued by concerns about patent expirations.

Although the industry will continue to face headwinds, some health fund managers argue that the stocks now represent compelling values. The portfolios of health funds now have price-to-earnings ratios of 14. That is below the P/E of the S&P 500. Blue-chips such as Merck ( MRK) and Eli Lilly ( LLY) trade at forward P/Es of less than 9. In the past, health stocks typically traded at a premium to the market. "After going through a period of underperformance, the health care stocks are universally cheap," says Erin Xie, portfolio manager of BlackRock Health Sciences Opportunities ( SHSAX).

Managers at fund company T. Rowe Price ( TROW) say that health care reform will hurt some stocks but that not all businesses will suffer. In many cases, the market has over-reacted to the bad news, T. Rowe Price argues.

Shortly after the legislation passed in March 2010, some companies announced that their earnings for the year would be 2% to 5% lower than analysts expected. That surprised investors and sent the stocks lower. This year companies are reporting additional costs.

Morningstar pharmaceutical analyst Damien Conover estimates that health care reform will cost the drug industry $100 billion in the next decade. Under the legislation, health companies will have to pay $28 billion in fees to support the drug programs of Medicare and Medicaid. Drug companies also will have to rebate Medicaid $2 billion annually. In addition, the industry is required to spend $35 billion to subsidize patients who face the "doughnut hole," bills that are not covered by Medicare Part D.

Although the costs are steep, they will be offset by increased revenues that will come when 30 million more people get health insurance. Morningstar says the extra patients will help to raise industry profits by $76 billion. On balance the net cost of health reform will be $24 billion, a small factor for an industry that should report $1.5 trillion in profits over the next decade.

To own some companies that could be among the sector's fastest growers, consider Franklin Biotechnology Discovery ( FBDIX), which has returned 3.2% annually during the past five years, outdoing 58% of competitors.

Portfolio manager Evan McCulloch concedes that patent expirations will take a big toll on the industry. Within the next several years, many drugs will come off patents, and the drug companies simply don't have enough products in development to replace the lost revenues. Still, he argues that some companies will continue to develop winning drugs.

A favorite holding is Gilead Sciences ( GILD), which makes HIV drugs. The shares sell for a modest forward P/E of 9.4. The company will have to make increasing payments to Medicaid, but new products in the pipeline should boost sales in the next several years, he says. "They hold a 70% share of their market, and the business generates a ton of cash," says McCulloch.

He also likes Ardea Biosciences ( RDEA), which makes drugs for treating gout. The company has promising drugs that are making their way through clinical tests, McCulloch says.

To hold a broad collection of health stocks, consider BlackRock Health Sciences, which has returned 7.2% annually for the past five years, outdoing 97% of competitors. The fund has 18% of its assets in biotech companies, 20% in drug makers, and 16% in managed care. Portfolio manager Erin Xie is particularly keen on companies that make medical devices and equipment. "The best device companies have good franchises and steady cash flows," she says.

A portfolio holding has been St. Jude Medical ( STJ), which makes defibrillators and other equipment used to treat heart patients.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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