Review & Outlook

Our take on the investing, financial, & economic themes of the day

Good Values In An Out-of –Favor Health Care Sector

9 March, 2011 by Ben O'Brien in Commentary

Health care represents about 18% of the economy (GDP) and is a significant portion of the overall investable market (about 11% of the Standard & Poor’s 500-stock index).  As such, health care stocks have a place in any diversified portfolio of stocks.  Still, there are plenty of reasons to avoid the sector.  Top among them is unpredictable government involvement.  Calls for reform have been a feature of the sector since the early 1900s.  Government’s reach into health care extends from regulation to its role as a key payer for products and services.  The complex relationships among politicians, patients, payers, product makers, and service providers are unlike any other industry.  The life-cycle of drug from drug development phase to patent expiration adds additional elements of uncertainty.  Frequently clinical events make investing in health care an all or nothing proposition.  And then a successful product or service faces a bewildering number of reimbursement systems.  Since a successful drug has a limited high-profit phase, there is always a question of what next.  Competition from other drugs can lead to obsolescence even sooner than expected.  Legal challenges present additional areas of concern.  It seems a lot to overcome in order to generate returns for shareholders.

A few companies meet the challenge. We are thinking of Johnson & Johnson and Abbott Lab. First the criteria experts say (we draw from Lest Funtleyder’s Health Care Investing) an investor should look for in a health care stock: a sustainable competitive advantage, good markets, strong management, a history of innovation, a conservative approach to accounting and setting expectations for sales and earnings growth, shareholder friendly policies, profitability with modest needs for capital, a good understanding of referral channels, reimbursement sources, and service areas, the ability to deal with wide-ranging compliance issues, strong insider ownership, and above all, the ability to improve quality of care, cost of care, or access to care.  It also helps if a company is in-sync with reform efforts and has the ability to profit from at least one of the following trends in health care:  personalized medicine, demographics, emerging infectious diseases, acute conditions becoming chronic, medicalization of conditions, consumerism, and globalization.

Johnson & Johnson meets most of the criteria. The company has leading positions in many of its businesses.  It is the world’s largest medical technology company, the seventh largest pharmaceutical concern, and the fourth largest biotech business.  Johnson & Johnson has a $7 billion research and development budget (over 10% of sales) for future innovations.  The company is so big that it can play a role in shaping health care policy around the world, and its global presence means it is well positioned for trends of globalization.  The company’s expertise and business strategies are aligning with several evolving trends in health care:  personalized medicine, comparative effectiveness, and wellness and prevention.  The company has a long history of consistent earnings growth and conservative EPS guidance.  Recent issues with large product recalls involving Tylenol and Pepcid (among others) have given us concern about management, but ultimately we agree with Valueline’s summary:  “the company is the undisputed world leader in the healthcare products industry, and things will eventually get better.”  In the meantime, shareholders are receiving 3.6% yield as they wait.

Abbott Labs is another company that measures up.  Since the Depression the stock has increased its dividend annually.  It just increased the dividend the other day (presently it matches JNJ’s at an annual rate of 3.62%).  This annual dividend rate exceeds the yield of a 10-year Treasury bond.  Granted, over the past ten years, the stock has done nothing (like Johnson & Johnson) but that’s not because the company hasn’t been making money.  It has. The company’s earnings more than doubled over the period, to the result that the stock at 11 times earnings is today half as expensive as it was ten years ago, when it sold at 26 times earnings.  The company spends $7 billion a year on developing new products, and year in and year out it has earned more than it earned in the previous year.  It sells its products all over the world, so it’s not tied to what might be a stagnant US economy.  And it is a consistent earner of money – – it held up beautifully during the crash of 2008.

In sum, you do not have to be very right to make money with Johnson & Johnson and Abbott Labs (and some other stocks in the sector, like Medtronic).  Moreover, if you are totally wrong about their long-term prospects, you still make money from the bond-like dividend. Other safe havens, such as commodities like gold or silver, require your analysis to be spot on accurate.  If it is wrong, you are stuck, because there’s no dividend. You are not paid while you wait; rather you have to pay a gold or silver storage fee.  Lastly gold and silver don’t develop new products or help anyone, apart from sending a message to the politicians that you don’t trust them. That may be an important message, but the theme for another comment.

Mark O’Brien

Sally Sulcove

Ben O’Brien