Street Talk: Looking for a Safe Haven in US Stock Market? Rx Might be Healthcare

For my money, 2006 found the healthcare sector in sickbay. For much of 2006, the healthcare sector, particularly the biopharmaceutical sector, found itself fighting myriad problems: anemic pipelines, widespread patent expirations; higher costs, and a slew of legal and regulatory threats that saw no shortage of industry lawyers in the courtrooms and in front of Congressional panels for much of the year. Not helping the industry was the election of a Democratic Congress, which triggered a four-point drop in the American Stock Exchange Biotech Index in the days after the November election.

Brian O'Connell

BUT THAT WAS THEN AND THIS NOW

With the stock market cratering in February, a recent series of iffy economic reports, and seemingly contrasting views on the direction of the US economy between the current and former Federal Reserve Chairmen, healthcare looks like a strong defensive play in 2007. Analysts project that the S&P Healthcare Index will post an earnings increase of 11% in 2007, compared with 5% profit growth for the S&P 500.

That, among other factors, could put a stake in a healthcare mutual fund or exchange-traded fund (ETF) in play—a good defensive stance when investors are taking a hands-off approach to more aggressive sectors. More aggressively, as I'll point out in a moment, is a healthy position in a private healthcare insurer or drug store chain now that Medicare Advantage seems to be taking off.

HEALTHY SECTOR

There's more to the healthcare sector than just bad economic news and a spat between Ben Bernanke and Alan Greenspan over whether the US is headed for a recession or not. Sure, with US economic growth faltering a bit, a defensive sector like healthcare should attract more attention. But there is also plenty of good news coming out of the sector in 2007, most notably:

• Strong valuations

• Tighter cost controls

• A slate of impressive new drug development pipelines

• Solid balance sheets.

A host of sector analysts see the same scenario I do.

Says Global Insight, the Boston-based analytical group: "Among the 10 sectors that comprise the US stock market, the healthcare sector currently has the best attributes for an overweight position, from both the fundamental and risk perspectives. This is due to the robust prospects for strong growth in earnings and free cash flow that result from positive demographics, new technology, faster sales, and positive pricing power."

Much of the bullish attention on the sector is honing in on biotech, where the historically volatile industry seems to be calming down and shaping up in 2007. "We see impressive pipelines and we've seen an increase in biotech's willingness to charge and receive premium pricing," says Eric Schmidt, a managing director at Cowen who is bullish on healthcare this year.

A good, safe fund like the Vanguard Health Care Fund fits well in this increasingly rosy scenario. Fund manager Ed Owens is a veteran, steady hand at the helm. He's been with the fund since 1984.

The guy knows the landscape. Take 2006—in a year when healthcare stocks underperformed relative to other key S&P Indexes, Owens looked overseas to the fund's European and Japanese pharma holdings, such as Roche and Takeda Chemical, which helped pump up returns and made the fund outperform last year. (The fund returned 10.87% last year, well ahead of its benchmark S&P Healthcare index).

Adaptability is Owens' calling card, for example, the fund averages about 30% of its holdings from overseas companies, and it has paid off handsomely over the years for fund investors.

PROWLING FOR PROFITS? THINKING CREATIVELY

Investors should also scour the landscape and think creatively when investing in healthcare this year.

Take the new Medicare drug plan that Washington belched out in 2004. At first glance, investors and prescription drug users greeted the new Medicare plan like Yankee Stadium greets Manny Ramirez on opening day with a traditional Bronx cheer.

The media set the table, as usual. Pundits called the plan cumbersome, inefficient, and inflexible. And those were some of the nicer things they had to say about it. But when the dust settled and the veil lifted, millions of Americans began signing up for the plan.

According to the Medicare Advantage web site, 19% of eligible Americans are enrolled in a private Medicare plan from either Humana, UnitedHealth, and a smaller handful of other providers. That's up from 11% in mid-2004. The future looks bright for Medicare Advantage, too. Investment banking giant Citigroup estimates that 25% of Medicare-eligible Americans will enroll in Medicare Advantage by 2009.

So what, you might say? Well, to defensive investors looking for profit potential in what is shaping up to be a down year on Wall Street, companies that profit from Medicare Advantage are poised for a bull run. Says Citigroup analyst Charles Boorady in a February research report on private Medicare firms and Medicare Advantage, "Enormous growth prospects remain" in the private healthcare sector in 2007.

Some of that growth has become readily apparent already. Healthcare insurance behemoth Humana saw its earnings rise from 46 cents-per-share ($3.7 billion) to 88 cents-per-share in the fourth quarter of 2006. Humana is a major player in the private Medicare healthcare market and is reaping the dividends of rising consumer interest in Medicare Advantage. Writes Prudential healthcare analyst David Shove in a January, 2007 research paper, "We suspect that Humana may see earnings upside between a nickel and dime during 2007 as a result of this increase in (Medicare Advantage) participation."

Or look at UnitedHealth, which survived a major accounting mishap (at least $286 million worth of stock options were misstated in 2006, causing the company to adjust earnings by $1.55 billion), and the subsequent ouster of its CEO Dr. William McGuire, to post decent gains so far in 2007. Through mid-March, UnitedHealth, another big player in the Medicare Advantage sector, saw its stock rise from $50 per share to $54 per share after the Medicare enrollment numbers came out.

Savvy investors might want to start thinking about drug store chains that may also benefit from the prescription drug component of Medicare Advantage. Drug store retailers like CVS and Longs Drugs Store are at the top of the list in participating Medicare Advantage outlets. CVS has seen its stock price rise from about $27 per share to $33 per share after the new Medicare plan enrollment numbers were published. Longs has done even better, jumping 10 points from $42 per share to $52 per share since December, 2006.

It all adds up to a major long-term buying opportunity in healthcare in 2007. The key ingredients are all there for investors—an economy expected to slow in 2007, a record number of Baby Boomers hitting 60, and a market move away from aggressive stocks and into defensive ones.

That should get the healthcare sector and its beleaguered investors out of critical care and into some flush financial times.

Celebrity author and business/finance commentator for CNN and Fox News, Brian O'Connell has written for The Wall Street Journal and Newsweek, Doylestown, PA , 267.880.3144, brian.oco@verizon.net