A dearth of new blockbuster drugs? The threat of more Medicare cuts looming over hospitals and other managed-care providers? Investors may be tempted to run from health-care stocks. But they would be missing out on the robust returns to be made from niche companies that are less susceptible to these ills.
With drugmakers, that means skipping Big Pharma and looking instead at nimble manufacturers of generics and small specialty drugmakers. Branded drugs that currently rack up nearly $60 billion in annual U.S. sales -- including anti-cholesterol drugs Zocor and Pravachol, and antibiotic Zithromax -- are scheduled to come off patent in the next three years. "It's one of the biggest waves of patent expirations in history," notes Edwin C. Ciskowski, research analyst at Lincoln Equity Management LLC in Chicago.
That's a big opportunity for generic makers such as Israel's Teva Pharmaceutical Industries Ltd. (TEVA). If it simply holds on to its current 20% share of the U.S. market, it could reap an extra $3 billion in annual sales because most generics sell for about a quarter of their brand-name versions, says Ciskowski. He believes Teva's stock, now trading at around $66 on NASDAQ, could hit $82 in the next 12 to 18 months.
Companies with a knack for finding new uses for existing drugs could also shine. Cephalon Inc. (CEPH), based in West Chester, Pa., will soon begin final trials to win Food & Drug Administration approval to use Gabitril, an epilepsy drug, to treat anxiety disorders -- a $16 billion-a-year market. Cephalon shares, now trading at $53, could run as high as $70 in the coming year on the strength of Gabitril and other drugs, says Viren Mehta, managing member of Mehta Partners LLC, a New York research firm.
The long-awaited jobs recovery could be a boon to some health insurers. As usual, small businesses are leading the way in hiring. That boosts companies such as American Medical Security Group Inc. (AMZ), of Green Bay, Wis., which writes health coverage for outfits with 10 or fewer employees. Profits are already growing at 15% to 20% a year, but American trades at just 12 times estimated 2004 earnings, vs. 15 to 18 times for mainstream insurers. "American plays in the end of the market that's so small they're under the radar," says Sheryl R. Skolnick, analyst at Fulcrum Global Partners LLC in New York. She believes that the insurer, now trading at $27, could hit $34 in 12 months as the hiring boom swells its membership rolls -- and profits.
Small is beautiful for hospitals, too. The trend among insurers to curtail costly hospital stays plays right into the hands of small specialty surgical centers, which can perform many outpatient procedures cheaper than bigger chains. United Surgical Partners International Inc. (USPI), which operates 74 outpatient centers in the U.S. and Europe, is well-positioned. While many medical professionals view such outfits as a threat to their businesses, United Surgical often teams up with local doctors and even nonprofit hospitals such as Baylor University Medical Center -- relationships that help ensure a steady stream of customers for its centers. Jeff Villwock, an analyst at Caymus Partners LLC, a boutique investment-banking firm in Atlanta, believes that United Surgical is a bargain because its price-earnings ratio based on forecast 2004 earnings is only a little higher than its 20% earnings-growth rate.
For more than a decade, health-care investors have been trained to think big -- big drug companies, big hospital chains, big insurers. But given the sea changes sweeping through the industry, investors thinking small may find themselves reaping healthier profits.
By Dean Foust in Atlanta