Despite solid earnings gains, the sector has lagged for years. That's changing. By David Landis, Contributing Editor November 28, 2007 Although rising health-care costs are taking a bigger bite out of employers' profits and workers' paychecks, health-care stocks have been languishing for years. Operating earnings for Standard & Poor's health-care sector have grown close to 12% annually over the past three years, yet the stocks on average have climbed only 10% a year. That's a curious disconnect. Once investors connect the dots, health-care stocks should, well, get healthy.Health-care companies have no shortage of concerns hanging over their heads. There have been high-profile product recalls (think Vioxx), and the Food and Drug Administration has become more cautious about approving new treatments. In addition, Congress is under pressure to rein in costs by squeezing providers of medical products and services. Health care will be front and center in next year's presidential race, and uncertainty will hang over the industry at least until then. RELATED LINKS Five Funds for Healthy Gains Medtronic: Still a Keeper The Kiplinger Mutual Fund Center Still, populations in most developed nations are getting older and will be spending more on health care. U.S. health-care spending, now $2 trillion a year, is expected to double by 2016 and account for nearly $1 of every $5 in goods and services that the U.S. produces. What's more, the health-care sector tends to be recession-resistant and so is particularly timely now that the U.S. economy seems on the verge of a slowdown. And the stocks are generally cheap. On average, they trade at 15 times expected 2008 earnings, according to S&P, which expects those earnings to grow 12% next year. "Bottom line, the industry has a lot of things working in its favor," says Scott Thoma, a health-care analyst with Edward Jones. Let's take a closer look at where the best opportunities lie. Advertisement The case for pharma Large drug manufacturers face a wave of expiring patents on their most profitable products over the next few years and are perceived as having done a poor job of developing new cash cows. But Laurent Payer, an analyst at Sectoral Asset Management, in Montreal, says the number of products in Phase II of the FDA's three-phase drug-approval process doubled between 1995 and 2005, and Big Pharma's ability to deal with patent expirations is improving. Meanwhile, these companies have been reducing costs, boosting their biotech-drug portfolios and continuing to generate a lot of cash, with which they are paying generous dividends (yields average 2%). "Over the past seven years, the companies have done a lot in terms of restructuring and repositioning that's not yet recognized by the market," says Payer. Analysts recommend focusing on companies with diversified sources of revenue so a setback in a single drug wonUt bring down the house. A good example is Abbott Laboratories (symbol ABT). It boasts a blockbuster rheumatoid-arthritis drug, Humira, as well as drugs for HIV and obesity, a drug-coated coronary stent (which props open blocked arteries) nearing FDA approval, and strong sales of infant formula and other nutritional products. But the big story is Humira. Its sales grew 50% during the second quarter compared with the same period of 2006 and should approach $3 billion this year. The FDA has also approved Humira for treatment of two other arthritic conditions and Crohn's disease, a digestive disorder. Approvals to use the drug for other ailments, such as psoriasis, could lift sales even more. And the patent for Humira doesn't expire until 2016. One of Payer's favorite drug makers is Wyeth (WYE). It recently suffered setbacks in clinical trials for Pristiq, an antidepressant, and bifeprunox, a treatment for schizophrenia, and the company lost a court battle to fend off generic competition for its heartburn drug, Protonix. In mid October, the shares were down 26% from their 52-week high. Now, Payer says, the shares trade solely on the value of the firmUs increasing biotech portfolio, which brings in revenues of $5 billion annually. By his estimation, investors are essentially getting the rest of Wyeth's businesses almost free -- including its pharmaceutical, consumer (Advil, Robitussin) and animal-health products, with combined annual revenues of $16 billion. Frank Sustersic, a manager of Turner Investment Partners who helps run Touchstone Healthcare and Biotechnology fund, likes British drug maker Shire (SHPGY). It makes Adderall XR, a serious challenger to Novartis's Ritalin for treatment of attention deficit hyperactivity disorder. Diagnosis of ADHD, once regarded as a children's ailment, has been increasing in adults. Plus, European doctors' skepticism of the legitimacy of the ADHD diagnosis has waned. Patent protection for Adderall XR expires in 2009, but a successor, Vyvanse, is already in place. In addition, Shire recently launched promising treatments for Hunter Syndrome (a rare metabolic disorder) and ulcerative colitis, a chronic digestive problem. Advertisement Best of biotech Biotechnology companies are now generating the kind of growth and excitement once associated with big drug makers. But biotech firms have been held back recently by some of the same factors hampering Big PharmaQnamely, a more deliberate FDA screening process and a paucity of new products. However, says analyst Andrew Fein, of investment bank Collins Stewart, the number of Phase III trials -- the final hurdle a new drug must clear before it hits the marketQshould pick up in 2008 and create some excitement in the sector. Investors should tread carefully here. Because only a handful of drugs under development ever make it to market, it's best to own a group of stocks in the sector or stick with larger, diversified companies. Gilead Sciences (GILD), with a market value of $40 billion, easily fits into the latter category. The Foster City, Cal., firm is a leader in developing treatments for HIV, a market that is growing because of more-aggressive testing for the virus. HIV treatments account for about 70% of sales. Gilead is also developing a treatment for hepatitis C and, through an acquisition, has entered the market for cardiovascular drugs. The stock trades for 23 times next year's expected earnings, which doesn't seem high given that analysts expect earnings growth of 17% over the next few years. Another promising, well-established biotech play is Celgene (CELG), which boasts a recently launched cancer drug, Revlimid. The drug has received approval in the U.S. for treatment of multiple myeloma (a form of cancer that strikes the bloodstream) and has the potential to be approved in many more countries and for other forms of cancer. Morningstar analyst Karen Andersen sees sales of Revlimid hitting $2.8 billion by 2011, roughly double the firm's expected 2007 revenues from all sources. Advertisement United Therapeutics (UTHR) is a small but profitable biotech firm with one drug on the market, a treatment for high blood pressure called Remodulin. The Silver Spring, Md., company has been testing an inhaled version of the treatment, which at present must be injected under the skin or into a vein. An easier way to administer the drug could boost profits significantly, says Fein. The firm also has an ovarian-cancer treatment in the late testing stages. Winning with devices As with other parts of health care, device makers badly need new blockbusters to generate excitement and jump-start lagging share prices. In the meantime, the large companies that dominate the field boast diversified product portfolios, good cash flows and reasonable values. Medtronic (MDT) is a good example. The Minneapolis-based company is a leading maker of pacemakers, diabetic pumps and artificial spinal disks. Earnings growth has slowed from a better-than-20% annual pace earlier in the decade to about 15% now. The stock lost 11% on October 15, when the firm suspended sales of a component of one of its implantable heart devices that was linked to five deaths. Despite the setback, a broad product portfolio should produce plenty of cash for years to come. Medtronic has lifted its dividend for 30 straight years and is in the midst of a big stock buyback. Significant new products, including a drug-coated stent, are expected by 2009. Edward Jones's Thoma likes two leading makers of orthopedic devices, Stryker (SYK) and Zimmer Holdings (ZMH). Though neither company is expected to release blockbuster new products in the short term, they'll still see steady growth from new niche products and will benefit from the aging population and a growing incidence of obesity (which puts added stress on joints). Stryker, which has $1.8 billion in cash and virtually no debt, sells for 25 times next year's estimated earnings. But given its 20%-plus expected earnings growth, that's not bad. A slowdown in sales of Zimmer's knee-replacement products has taken a toll on its shares, which trade at a reasonable 18 times 2008 estimated profits. A more direct play on the increase in obesity is Allergan (AGN), maker of the Lap-Band, an adjustable band that restricts the size of the stomach and thus reduces appetite. The Lap-Band is a safer alternative to gastric-bypass surgery, says Touchstone's Sustersic, and insurers are increasingly willing to reimburse patients who choose to undergo the treatment. In addition, Allergan makes Botox and has a broad portfolio of breast-implant and eye-care products. It has been testing Botox as a treatment for overactive bladder. Advertisement Jeff Herrmann, co-manager of the Manning & Napier Life Sciences fund, likes ResMed (RMD), which makes devices to treat sleep apnea, a breathing disorder linked to high blood pressure, diabetes, obesity and other problems. The company estimates that 90% of cases go undiagnosed. But as awareness of the disorder grows, so should ResMed's profits. Analysts forecast 20% annual gains over the next five years. Rest of the best The uncompensated expense of having to treat patients who are uninsured continues to rise, and that depresses hospitals' bottom lines. Some analysts also warn that the reimbursement obligations of managed-care outfits are outpacing the premiums they collect and eating into profits. What's more, the managed-care industry may be vulnerable to potential moves by a Democratic-controlled Congress to rein in health-care costs. Still, many portfolio managers remain high on UnitedHealth Group (UNH). With more than 70 million customers, it has the size to succeed in a business in which scale matters. Its shares are also cheap, thanks in large part to lingering effects of a stock- option accounting scandal that required the firm to restate 12 years' worth of earnings. Investors have plentiful opportunities in other health-care subsectors. For example, clinical-research organizations, which conduct trials and other tests on behalf of drug makers and biotech firms, are awash in business, thanks to the FDA's insistence on amassing reams of data. Fund manager Sustersic likes Dublin-based ICON (ICLR) and Parexel International (PRXL), based in Waltham, Mass., both of which have strong U.S. and overseas operations and should see profit growth of better than 20% next year. Manning & Napier's Herrmann points out that increasing numbers of medical records are being stored electronically, which requires health-care firms to make greater technology investments. One company benefiting from that trend, he says, is Eclipsys, which provides a variety of hardware, software and consulting services to medical facilities. Second-quarter earnings more than tripled from the same period in 2006. Herrmann also likes PerkinElmer, a maker of medical instruments and supplies with a fast-growing franchise in genetic screening. The company dominates the market for newborn-screening services in the U.S., where more states are requiring increased testing; it also has a 50% market share of newborn testing in China.