Health-Care Stocks' Poor Prognosis

From hospitals to pharmaceuticals, the vital signs of this usually safe area's subsectors are displaying some troubling symptoms

By Sam Stovall

In this column, I normally spotlight an industry that has been added to the ranks of those with top Standard & Poor's . But this time I thought I would take a different tack and focus on what isn't on the list: any of the subindustries within the health-care sector.

True, the overall health-care sector has done a bit better than the broader market in 2002. Year-to-date through Nov. 22, the S&P Health Care Index fell 16.3%, vs. an 18.9% decline in the S&P Super 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600). But S&P recently lowered its opinion on the entire health-care group to underweight (meaning that investors should decrease their exposure to the sector) from marketweight. Robert Gold, who heads S&P's Health Care Sector Group, says that some of the sector's relative outperformance this year can be attributed to a brief rally among pharmaceutical stocks following the Republican election victories, as well as investor rotation into defensive areas of the market.


  And S&P believes that the entire sector may now suffer. Within the hospital group, there has been erosion of valuation stemming from reports that some industry players' Medicare billing practices are being investigated. Given the ongoing fundamental challenges facing the pharmaceutical subindustry, S&P thinks investors should be cautious about the entire sector over the coming months.

What about the prospects for the individual industry groups? Medical technology stocks should perform well into 2003, Gold says, aided by new product approvals in fields such as cardiology, orthopedics, and diagnostics. The revenue outlook for device makers' has improved thanks to favorable swings in the euro and yen relative to the U.S. dollar. Their gross margins are benefiting from the improved pricing power associated with these new technologies. S&P believes that the Food and Drug Administration's efforts to speed medical device approvals bode well for 2003 and beyond.

Within the biotech group, S&P thinks that lofty valuations for some in the area can be justified by recent drug approvals as well as FDA efforts to streamline drug approval. But some in this group face balance-sheet concerns as they are hampered by both high cash burn rates and tightness in the equity and debt markets.


  The outlook for the pharmaceutical group continues to suffer for several reasons: slowing growth rates amid heightened competition in key therapeutic categories, longer FDA product review times, and a flood of generic drugs. Product pipelines look anemic, with fewer blockbusters on the horizon. Despite this, Gold notes that pharmaceutical stocks, aided by their continued status as a relatively safe haven in a volatile equity market, have generally performed in line with the S&P 1500.

Gold says the picture for hospital and HMO stocks has soured (see BW Online, 11/26/02, "Managed Care: Taking a Breather?"). Rising federal budgetary pressures and persistent economic softness have significantly jeopardized the group's forward pricing power and clouded revenue and earnings forecasts.

S&P Relative Strength Rankings

These industries carry 12-month relative strength rankings of "5" as of Nov. 22, 2002 -- meaning that they're in the top 10% of the 116 industries in the S&P Super 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600) based on prior 12-month price performance.

Industry/Sector Largest Company (Market Cap.) S&P STARS* Rank
Apparel, Accessories & Luxury Goods/Consumer Discretionary Quiksilver (ZQK) 5 STARS
Brewers/Consumer Staples Anheuser-Busch (BUD) 4 STARS
Casinos & Gaming/Consumer Discretionary Harrah's Entertainment (HET) 4 STARS
Consumer Electronics/Consumer Discretionary Harman International (HAR) Not Ranked
Distillers & Vintners/Consumer Discretionary Constellation Brands (STZ) 5 STARS
Gold/Materials Newmont Mining (NEM) 5 STARS
Homebuilding/Consumer Discretionary KB Home (KBH) 5 STARS
Housewares & Specialties/Consumer Discretionary Fortune Brands (FO) 4 STARS
Metal & Glass Containers/Materials Pactiv (PTV) 5 STARS
Photographic Products/Consumer Discretionary Eastman Kodak (EK) 1 STAR
Trucking/Industrials Yellow Corp. (YELL) 5 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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