Managed Care Won't Get Much Healthier

While the industry's growth prospects remain strong, share prices post-2003 aren't likely to continue their recent run-up

By Sam Stovall

Recently added to Standard & Poor's -- the list of industries with top S&P Relative Strength rankings -- are companies that operate managed-care organizations (MCOs), such as HMOs. Those outfits have been mostly immune to the ills affecting the overall market. Year-to-date through Feb. 28, the S&P Managed Health Care index fell 2.6%, vs. a 4.6% decline for the S&P Super 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600). In 2002, the subindustry index rose 5.2%, vs. a 22.5% fall for the 1500.

I asked Phillip Seligman, S&P's managed-care analyst, if the group's inclusion in the Industry Momentum portfolio indicates that higher stock prices are to come. Despite his belief that managed care's long-term prospects are bright, Seligman thinks investors may believe that all the good news for 2003 is already out and that post-2003, performance won't be as good.

According to Seligman's most recent industry report, the group should continue to deliver strong earnings growth, fueled by premium price hikes in the 15% to 18% range. That should outpace medical-cost inflation, which is expected to be several percentage points lower.

NEW PRODUCTS.

  However, the analyst notes that employers are taking stronger positions against rising premiums by cutting expensive options and reducing rate hikes in favor of higher co-payments -- a practice known as buydowns. Most MCOs are likely to experience increases in their medical-cost ratios, or the direct costs expended on health care as a percentage of total premium revenues. In light of buydowns, the premium-rate yields realized by MCOs can be up to three percentage points lower than the rate hikes, narrowing the gap with medical cost trends. Indications are that medical-cost trends will moderate.

Nevertheless, to attract accounts, MCOs have reduced their premium growth rate to more closely match medical-cost trends and have developed consumer-directed products that have helped reduce overall medical costs. These products have only recently been introduced and aren't widespread, so their effect on the industry hasn't been felt yet. Also, to offset rising medical-cost ratios, MCOs are aiming to reduce their selling, general, and administrative costs by improving information-technology systems to further automate transaction processing and consolidate service operations.

President Bush's vow to veto patients' rights bills being considered by the Senate because damage awards would be costly and would lead to higher premiums could be good news for the MCOs. And Congress has put managed-care reform on hold to focus on the war on terrorism and on the economy.

LOWERED RATINGS.

  Seligman expects earnings of publicly traded MCOs to increase 15% to 20% on average in 2003, after a similar gain in 2002. Well-run MCOs with strong underwriting skills, good cost controls, and a stable of attractive products should be able to sustain this earnings growth for the longer term.

However, many investors, reflecting a view that the economy can only improve from here, may now wish to reinvest profits from the run-up enjoyed by these defensive stocks in the past few months into cyclical or higher- beta issues. In the past few months, Seligman has reduced his opinion on his top picks in the group, Anthem (ATH ), UnitedHealth (UNH ), and WellPoint (WLP ), to 4 STARS (accumulate) from 5 STARS (buy).

Industry Momentum List Update

For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the 116 industries in the S&P 1500) as of February 28, 2003.

Industry/Sector Largest Company (Market Cap.) S&P STARS* Rank
Consumer Electronics/Consumer Discretionary Harman International (HAR ) Not Ranked
Distillers & Vintners/Consumer Staples Constellation Brands (STZ ) 5 STARS
Diversified Metals & Mining/Materials Phelps Dodge (PD ) 3 STARS
Gold/Materials Newmont Mining (NEM ) 4 STARS
Managed Health Care/Health Care UnitedHealth Group (UNH ) 5 STARS
Internet Software & Services/Information Technology Yahoo! (YHOO ) 1 STAR
Metal & Glass Containers/Materials Pactiv (PTV ) 4 STARS
Office Electronics/Information Technology Xerox (XRX ) 2 STARS
Oil & Gas Drilling/Energy Nabors Industries (NBR ) 5 STARS
Oil & Gas E&P/Energy Apache (APA ) 5 STARS
Water Utilities/Utilities Philadelphia Suburban (PSC ) 4 STARS

*S&P's ranking system for the appreciation potential of stocks over a 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell).

Stovall is chief investment strategist for Standard & Poor's

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