A Cure for Anemic Portfolios

In good times and in bad, drugmakers and hospitals thrive

If you're feeling sick about the bear market, you could take two Tylenol and hope for a recovery. Or you could buy shares of Tylenol's manufacturer, Johnson & Johnson (JNJ ). Health-care stocks often outperform during periods of economic stress. Unlike such sectors as gold or food, which prosper mainly in recessions, health care also thrives in boom times. Four of the 10 top-performing mutual funds over the past 15 years specialize in health care.

Why the resilience? People may forgo vacations and fancy dinners during a recession, but they don't stop taking their medication. "Most drugs and medical procedures are not discretionary," says Frank Sustersic, portfolio manager of the Turner Healthcare & Biotechnology Fund. "They're very necessary." Moreover, demographics favor health care. According to the U.S. Census Bureau, the percentage of Americans over age 65 should rise from a current 12.5% to 20% by 2030. "That's the slice of the population that accounts for 40% of health-care expenditures," says Robert Gold, a health-care analyst at Standard & Poor's.

Even with the bright prospects, health-care stocks still get pummeled if overvalued. Indeed, the sector is down 14% so far this year (which still beats the 21% decline in the Standard & Poor's 500-stock index). According to Turner's Sustersic, health stocks have historically traded at a forward price-earnings ratio (based on projected earnings for the next 12 months) that is 10% to 40% higher than the S&P 500's average p-e. The average stock in the S&P Health Care Index has a 23.7 2002 p-e, compared with the S&P 500's 17.7, a lofty 33.9% premium. But the premium is likely overstated. That's because earnings for other sectors will fall more than those in health care. That will raise the S&P 500's p-e, bringing it closer to that of the health-care index.

TOUGH TIMES. Yet resiliency is not immunity. "Health-care profits don't decline during a recession," says portfolio manager Samuel Isaly of the Eaton Vance Worldwide Health Sciences Fund, "but their growth slows down." Indeed, tough times induce patients to seek less expensive substitute drugs or procedures, squeezing profit margins. A good example is Merck's Vioxx, an arthritis drug that's pricier but has fewer side effects than competing "super-aspirin" drugs. "Merck (MRK ) thought Vioxx would sweep this drug class," Isaly says, "but the acceptance rate has been lower than expected because of its higher price." So, Merck recently had a profit warning.

The best companies offer either niche drugs or products that are vastly superior to their peers'. Isaly points to Novartis (NVS ), which recently received Food & Drug Administration approval to sell Gleevec, a drug to treat chronic myeloid leukemia. "This drug works where nothing else does," says Isaly, "so Novartis can price it at a hefty premium." Another example is Pfizer's new Geodon, which is much more effective and has fewer side effects than competing schizophrenia drugs, says Michael Dauchot, portfolio manager of Dresdner RCM Global Healthcare Fund. "We think Geodon could capture 20% of the $3 billion-a-year market for schizophrenia drugs."

CHEAPER YET. To search for health-care stocks, you can use BusinessWeek's online screener. Simply go to businessweek.com/investor/stocks.html and look for "Investing Tools." Click on "Stock Screeners" and then "Advanced Stock Search." Under "Select An Industry," click on "Drugs." By setting "Company/S&P Growth Ratio" to a minimum of 0.6, you ensure that no drug-stock pick has a forward p-e more than 40% higher than the S&P 500. (If you want cheaper stocks, raise the minimum ratio to 0.8 or 0.9.) Also, set a minimum of 15% for "Proj EPS Next FY"--or projected earnings per share for the next fiscal year--and the same for "Proj EPS Annualized 5 Yr." That allows you to find companies with the highest earnings estimates. Stocks that make the cut include Teva Pharmaceutical, Pfizer, and Pharmacia.

The screener pulls up some biotechnology stocks, too--but only profitable ones. Most biotech companies are small and have undeveloped or fledgling product lines. They often need lots of cash to stay afloat; that capital has dried up in the slowdown. "Only about 20 biotech companies are currently making money off existing product lines," says Isaly. "They don't have any capital problems, but the ones that are pre-product we avoid." Of the profitable ones, his favorite is Genzyme (GENZ ), which makes Renagel, a kidney dialysis drug.

Yet certain unprofitable biotechs are so beaten up that some think they're buys. Dresdner's Dauchot is accumulating shares in Abgenix (ABGX ), Medarex (MEDX ), and Protein Design Labs (PDLI ), antibody manufacturers all down more than 50% this year. "These companies are trading at two times book value, which has historically represented their floor," he says. Scarce capital could also make them acquisition targets. "The shortage will force biotechs into the arms of larger drug companies, which can fund and market their products," says Sam Stovall, S&P's sector strategist.

One health industry that has held up well this year is hospitals, with the average stock up 8%. "Medicare and commercial health insurers are giving hospitals significant rate hikes, on average around 8% in 2001 and 2002," says S&P's Gold. Gold gives hospital giant Tenet Healthcare (THC ) five stars, S&P's highest rating. "Tenet has been going through a restructuring for the last two years, selling underperforming hospitals and acquiring ones in California, Florida, and Pennsylvania, which are heavily populated by the elderly," he says. Gold also rates HCA, the largest hospital company, five stars.

Medical-equipment stocks also hold promise, but it is hard to generalize about this industry. "Device companies cater to particular niche areas of health care," says manager Michael Yellen of the Aim Global Health Care Fund. "If their niche does well, they do well." Industry leader Medtronic (MDT ) focuses on pacemakers and defibrillators, which have higher profit margins than other devices, such as blood and plasma products manufactured by Baxter International. So Medtronic deserves a higher p-e than Baxter.

Stocks of HMOs and nursing-home operators have performed relatively well this year, but some managers are wary of them. "HMOs have increased their premium rates at double digits during the past couple of years," says Yellen. "Now that the economy is slumping, their corporate clients are pressuring them to bring those rates down." Nursing homes are reeling from cutbacks in Medicaid payments.

Still, the majority of health-care companies look robust right now. "Our portfolio should have a 15% earnings increase this year, while earnings for the S&P 500 will likely decline," says Isaly. "Yet our fund is down 15% in 2001." Such divergences won't last forever. At some point, the health-care stocks will catch up with their superior earnings growth. Then, if you own them, you won't need any Tylenol.

By Lewis Braham

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