What Ails Health Stocks?
Sorting through this troubled sector, we uncover six solid companies that are poised for gains. By Jon Birger
By Jon Birger

(FORTUNE Magazine) –

Picking stocks is an inexact science--so inexact you can be wrong even when you're right. Just consider the story we did on health-care stocks back in May 2004. (See "Rx for Investors" on fortune.com.)

We argued that the health-care sector would continue to outpace the broader stock market, just as it has since the mid-1990s, serving the medical needs of an aging populace. "There's no denying the sheer market potential of 75 million trick-kneed, Prevacid-popping, ointment-loving consumers," we wrote. "You can almost hear the cash registers ring."

Well, a year and a half later, the only thing ringing has been alarm bells. Concerns about drug patent expirations and meager new-product pipelines have sidetracked pharmaceutical stocks. Pharma industry tracker IMS Health expects growth in drug sales in 2006 to be the lowest in ten years. And in the medical devices arena, fierce competition and increased pricing pressure are crimping earnings growth. The Feds aren't helping either: In September, Guidant, Medtronic and St. Jude all said they'd received subpoenas from federal prosecutors investigating whether their sales staffs offered illegal kickbacks to doctors. The upshot: Standard & Poor's health care index has fallen 3% over the past 18 months, vs. a 6% gain for the S&P 500.

The good news, at least for FORTUNE readers, is that the ten health-care stocks we recommended have beaten the market: They're up an average of 12%. Even so, the success of our stock picks probably says as much about what's been ailing health care as it does about any future recovery.

There were four big winners among our choices: generic drug king Teva Pharmaceuticals, disease-management company American Healthways, hospital IT company Cerner, and pharmacy-benefit manager Omnicare. All these companies--whose 18-month returns ranged from 24% to 92%--are in the business of reining in rising medical costs, not reveling in them. Teva's products include generic versions of once-pricey blockbusters like antidepressant Prozac, allergy medication Allegra, and antibiotic Augmentin. American Healthways works on behalf of insurance companies. It has call centers staffed by nurses who phone patients with manageable diseases like asthma or diabetes to remind them to take their medicine or schedule tests--in hopes of avoiding costly hospitalizations. Its stock soared 61%. Compare that with one of our other picks, Zimmer Holdings, a maker of artificial joints. Zimmer's stock has tanked 23% on concerns about increased competition and pricing pressure.

Despite the market's handwringing, the fundamental case for health-care investing has changed little. Baby-boomers' clamor for health care will almost certainly outpace demand for computers, fashion, home electronics, or just about anything else historically tabbed as a growth industry. "Think of it this way," offers Sam Isaly, manager of the Eaton Vance Worldwide Health Sciences fund. "Have you already got a computer in your house?" (Rhetorical answer: yes.) "Well, I'm guessing you don't have a new cancer treatment in your house. And which do you need more: a cancer treatment or a faster Internet connection?"

That's the long-term case for health-care stocks. There's a short-term one too. Federal Reserve rate hikes, higher energy costs, and a cooling real estate market all point to slower growth in 2006. A.G. Edwards market strategist Al Goldman says that investors are likely to swap out of cyclical sectors--technology and housing, for example--into more defensive areas like health care. "When bull markets and economies start putting on some age, the bigger-name defensive growth stocks get more attention," says Goldman.

With the recent health-care selloff, bargain hunters have a lot of such issues to chose from. Among the stocks we discussed in 2004, Stryker (SYK) and Teva (TEVA) look like the best buys right now. Though Teva has returned 24% since we recommended it, it is still reasonably valued, with a price/earnings ratio of 20, well below its five-year average of 29.

Stryker--down 19% since we cited it--is a medical-device company active in hip and knee replacement, a business where hospitals seem to be rebelling against the 45% price increases since 2001. Still, even if the price of joint replacements were to flat-line, UBS analyst Patrick Pace thinks Stryker earnings would rise 18% next year on volume growth and the strength of Stryker's other business lines, such as surgical instruments. Pace has a $69 target price for Stryker, which in late October traded at $40 a share and 20 times expected 2006 earnings.

Among other stocks we expect to bounce back are two of the sector's biggest names, Pfizer (PFE) and Amgen (AMGN). In the case of Pfizer, investors have been spooked by the fact that the drugs coming off patent now and over the next few years (including Zithromax and Zoloft) represent about 25% of the company's existing sales. Also, although Pfizer recently survived a patent challenge in Europe to Lipitor, lower-priced competition is cutting into sales of the blockbuster anticholesterol drug. Florida's Medicaid program recently dropped Lipitor from its list of approved drugs. That came on the heels of a similar move by pharmacy-benefit manager Express Scripts. The final straw for a lot of money managers came in October, when Pfizer withdrew its earnings guidance for 2006.

Pfizer stock has tumbled 25% since June; at $21 a share, it's trading at ten times estimated 2006 earnings, less than half its five-year average forward P/E. Says Todd Lowenstein, who has been buying Pfizer in his HighMark Value Momentum fund: "As value players, we see a company with a bulletproof balance sheet--$15 billion in cash and no net debt. They're generating $8.5 billion a year in free cash flow, and when you add in the 3.6% dividend yield, you're looking at a 10% cash return for this company." Another value manager, Bill Fries of Thornburg Value, says that even in the unlikely even that Pfizer's earnings were to rise only 5% or 6% a year over the next eight years, he calculates that the stock is still worth $2 more today than its current price. "We think Pfizer is a secure company that's going through a rough patch with some of its products," he says.

The problems at biotechnology leader Amgen don't run nearly as deep, but you wouldn't know it from its recent stock market performance. The stock fell 15% from mid-September to late October, mainly because of weaker-than-expected sales growth in the third quarter. "I was surprised by the reaction," says Brandi Allen, co-manager of the Live Oak Health Science fund. "There's still a lot of growth in their core products." Indeed, sales of Aranesp (anemia treatment), Neulasta (infection-fighter for chemotherapy patients), and Enbrel (rheumatoid arthritis) are all expected to increase more than 30% this year. Plus, Amgen's new-drug pipeline includes promising treatments for colon cancer, gastrointestinal cancer, and bone disease. For all these reasons, Citigroup analyst Elise Wang believes Amgen is worth $100 a share, 35% above where it traded in late October: "In our opinion, Amgen remains one of the most attractive large-cap growth stories in health care."

Another group of health-care stocks that have also taken it on the chin lately are life sciences companies like Invitrogen (IVGN) and Waters (WAT), which make equipment used in new-drug research. Recent sales and earnings have been disappointing, which is why the stocks are down 20% and 29%, respectively, from their 2005 highs. Allen sees a buying opportunity. "Toward the end of every year, investors get nervous about what the National Institutes of Health [research] budget is going to look like for the next fiscal year," she says. "I don't see how the NIH could make drastic cuts in growth rates given the concerns about avian flu and bioterrorism." Also, new tax laws are making it easier for U.S. companies to "repatriate" overseas earnings. Pfizer, for instance, has already said it will bring back $37 billion in foreign earnings. Says Allen: "That's going to enable them to spend more on R&D, which benefits these tools companies."

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Six Healthy Choices

The health-care sector is in Wall Street's doghouse--which makes now a good time to buy.


Data as of Oct. 27. Price/earnings ratios based on estimated 2006 earnings.