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Health Care Provides Shelter from Economic Storm

Use this screen to find the best of health-care stocks, which historically tend to perform independently of the economic cycle.

Justin Fuller, 08/04/2008

Over the past several recessions, health-care stocks haven't skipped a beat and have shown strong resilience to a slowing economy. As the U.S. economy approaches a recessionary period, several health-care stocks should again generate consistently strong growth.

While uncertainty remains to the degree and length of the impending recession, health-care stocks as a whole should perform well regardless of the severity of the downturn. Our analysis shows that over the past several recessions, health-care stocks showed very minor correlation to the economy's growth. (See Is Health Care Immune to a Recession? for more on this topic.) We believe that the inelastic nature of health-care goods and services keeps demand high even when consumers face declining disposable income. Further, a large amount of health-care spending is composed of insurance payers, which shields consumers from the majority of expenses. Therefore, health-care stocks should offer a viable option in a slowing economy.

Morningstar tracks more than 1,000 health-care stocks, however, and sifting the winners from the losers is a challenge. Not all health-care stocks will perform well in recessionary periods. Further, many health-care stocks face company-specific risks that reduce the stocks' return potential. This screen seeks health-care stocks with the highest return potential in a slowing economy. We performed this screen in May in Morningstar Principia with April month-end data. An equivalent screen can be created in Morningstar Advisor Workstation Office Edition.

Initially, we want to group only the health-care companies out of the total stock universe:

Sector = Healthcare

Second, we want to avoid small companies, where slight missteps are magnified in a weakening economy. Lacking the diversity of several operations, small firms tend to focus on particular niche industries. In a weak economy, a small company's sole business line faces a greater risk of reduced demand. Without the stability of multiple operating divisions, any problems arising to the core business may result in the need to raise capital to get past the rough patch. In a recessionary period, generating additional capital through equity offerings can greatly dilute the existing shareholder base. As a result, we want to include only companies with market caps greater than $1 billion.

And Market Cap > 1000.00

Further, the credit markets have created major problems for companies carrying large amounts of debt. Even companies with reliable streams of cash flow can encounter challenges in the current credit markets. While health- care companies tend to carry a lower debt burden than companies in other sectors, to eliminate companies with heavy debt loads we set our debt/total cap ratio to less than 40%.

And Debt to Total Cap Year 1 < 40%

Next, we want companies that generate strong returns on equity. Setting our ROE constraint to at least 20% should ensure that we get only companies that are yielding returns in excess of their cost of capital. Additionally, setting our ROE minimum to 20% should pick companies that are creating significant economic value.

And ROE % 1 year > 20.0

Further, we want to eliminate highly valued stocks. While we may be giving up some stocks with strong growth potential, we are eliminating the evaluated risks of growth stocks in recessionary periods. In downtimes, stocks with lofty P/E multiples tend to fall fast on any negative news. Also, the odds of negative news flow are increased when the economy is slowing.

Thus, we set our maximum forward P/E multiple to 18.

And Forward P/E Ratio < 18

Finally, we incorporated our analysts' insights by including only 5-star stocks. Several quantitative and qualitative measurements are evaluated to derive the star rating. After an in-depth analysis of the risks and growth potential for a company, conferring a 5-star rating means the analysts holds a high conviction in the stock. By selecting only 5-star stocks, we aim to target the best stock picks by Morningstar analysts.

And Morningstar Rating = 5 Stars

Our screen generated five health-care stock picks that should perform well as our economy slows.

Johnson & Johnson JNJ
Johnson & Johnson stands alone as a leader across the major health-care industries. The company maintains a diverse revenue base, a robust research pipeline, and exceptional cash-flow generation that together create a wide economic moat. Patent losses on antipsychotic Risperdal and neuroscience drug Topamax, as well as recent side-effect concerns with anemia drug Procrit, will weigh on near-term performance. However, we remain confident that the company's breadth can overcome these issues.

Novartis NVS
In an industry plagued by stagnant growth, Novartis emerges as a juggernaut with diversified operating platforms and an industry- leading number of new potential blockbuster drugs. Strong intellectual property supporting multibillion dollar products combined with a plethora of late pipeline products create a wide economic moat for the firm. Although the company faces near-term patent losses on hypertension drug Lotrel, fungal medicine Lamisil, and epilepsy treatment Trileptal, existing product lines and new products should more than offset these losses and offer stable long-term growth.

Luxottica LUX
Within the medical-device industry, Luxottica is the dominant force in the global eyewear market. In addition to being the world's largest manufacturer of prescription eyewear, the Italian firm is also the largest eyewear retailer through its Sunglass Hut, LensCrafters, and Pearle Vision optical shops. As a vertically integrated company, Luxottica has scale and distribution advantages rivals cannot match. For these reasons, we believe that Luxottica is well positioned for strong growth.

Medtronic MDT
This wide-moat company's vision is to establish a significant presence in chronic diseases, in addition to its historical stronghold in heart disease. Investments in neurological, diabetes, and spinal products from the middle to late 1990s have paid off in spades, offering new revenue streams and taking some pressure off heart products. Revenue from those three product areas inched up from 25% of total sales in fiscal 2000 to 41% in fiscal 2008. Medtronic's diversified medical-technology portfolio allows it to better weather glitches in the development or approval process for any particular new device. With its diversified portfolio and strategy to develop products for a wide range of chronic diseases, Medtronic is well positioned for long-term growth.

WellPoint WLP
WellPoint has significant competitive advantages that will support robust returns over the long run. Size is critical in managed care, and regional scale is even more important. WellPoint's Blue Cross and Blue Shield plans hold the leading brand in most of its markets. Additionally, WellPoint's shareholders were punished after the company lowered its 2008 forecast on March 10, citing higher medical costs and weaker-than-expected enrollment. We think the market overreacted, creating a buying opportunity for long- term investors.

Damien Conover, CFA, is an equity analyst with Morningstar.

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